Federal Tax Considerations for Life Insurance and Annuities Flashcards
Terms
LIFO (Last In, First Out) - principle applied to asset management in life insurance products, under which it is assumed that the funds paid into the policy last will be
paid out first
FIFO (First In, First Out) - principle under which it is assumed that the funds paid into the policy first will be paid out first
Policy endowment - maturity date
Policy proceeds - in life insurance, the death benefit
Surrender - early termination of a policy by the policyowner
Tax deductible - a reduction of taxable income, resulting in lower tax liability
Taxable - subject to taxation, payable to state and federal government
Tax deferred - taxes on investments or gains (such as interest or dividends) are paid at a future date instead of in the period in which
they are incurred tax
Vesting - the right of a participant in a retirement plan to retain part or all of the benefits
A. Taxation of Personal Life Insurance
A. Taxation of Personal Life Insurance
Generally speaking, the following taxation rules apply to life insurance policies:
• Premiums are not tax deductible; and
• Death benefit:
o Tax free if taken as a lump-sum distribution to a named beneficiary; and
o Principal is tax free; interest is taxable if paid in installments (other than lump sum).
Amounts Available to Policyowner
Amounts Available to Policyowner
As you have already learned, permanent life insurance provides living benefits. There are several ways in which policyowners may
receive those living benefits from the policy.
Cash Value Increases
Any cash value accumulations in the policy can be borrowed against by the policyowner, or may be paid to the policyowner upon
surrender of the policy. Cash values grow tax deferred. Upon surrender or endowment, any cash value in excess of cost basis
(premium payments) is taxable as ordinary income. Upon death, the face amount is paid, and there is no more cash value. Death
benefits generally are paid to the beneficiary income tax free.
Dividends
Dividends
Since dividends are a return of unused premiums, they are not considered income for tax purposes. When dividends are left with the
insurer to accumulate interest, the interest earned on the dividend account is subject to taxation as ordinary income each year
interest is earned, whether or not the interest is paid out to the policyowner.
Policy Loans
Policy Loans
The policyowner may borrow against the policy’s cash value. Money borrowed against the cash value is not income taxable; however,
the insurance company charges interest on outstanding policy loans. Policy loans, with interest, can be repaid in any of the following
ways:
• By the owner while the policy is in force;
• At policy surrender or maturity, subtracted from the cash value; or
• At the insured’s death, subtracted from the death benefit.
Know This! Policy loans from the cash value are NOT income taxable.
Surrenders
Surrenders
When a policyowner surrenders a policy for cash value, some of the cash value received may be taxable as income if the cash
surrender value exceeds the amount of the premiums paid for the policy. When the owner withdraws cash value from a universal life
policy (partial surrender), both the cash value and the death benefit are reduced by the surrender.
Example:
Consider the following scenario:
• Face amount: $300.000
• Premiums paid: $70.000
• Total cash value: $100.000
If the insured surrendered $30,000 of cash value, the full $30,000 would be income tax free. If the insured took out $100,000, the
last $30,000 would be taxable because the $100,000 exceeds the premiums that were paid in by $30,000.
- Amounts Received by Beneficiary
General Rule and Exceptions
- Amounts Received by Beneficiary
General Rule and Exceptions
Life insurance proceeds paid to a named beneficiary are generally free of federal income taxation if taken as a lump sum. An
excpption to this rule would apply if the benefit payment results from a transfer for value, meaning the life insurance policy is sold to
another party prior to the insured’s death.
Know This! Lump-sum cash payment of life policy proceeds are tax free for the beneficiary.
Settlement Options
With settlement options, when the beneficiary receives payments consisting of both principal and interest, the interest portion of the
payments received is taxable as income. For example, if $100,000 of life insurance proceeds were used in a settlement option paying
$13,000 per year for 10 years, $10,000 per year would be income tax free and $3,000 per year would be income taxable.
Know This! In settlement options, the principal is tax free, but the interest is taxable.
Taxation of Annuities
1. Individually-owned
Taxation of Annuities
1. Individually-owned
A portion of each annuity benefit payment is taxable, and a portion is not. The portion that is nontaxable is the anticipated return of
the principal paid in. This is known as the cost base. The portion that is taxable is the interest earned on the principal. This is known as
the tax base.
The exclusion ratio is used to determine the annuity amounts to be excluded from taxes. The annuitant is able to recover the cost
basis nontaxable. The cost basis is the principal amount, or the amount that was paid into the annuity, which is excluded from taxes.
The rest of each annuity payment is interest that has been earned and is taxable.
Tax-deferred Accumulation
The cost base represents the premium dollars that have already been taxed and will not be taxed again when withdrawn from the
contract. The interest accumulated in an annuity is the tax base, but the taxes are deferred during the accumulation period.
- Corporate-owned
- Corporate-owned
Corporate-owned annuities have different tax implications than individual annuities:
• Growth in the annuity is not tax deferred; and
Interest income is taxed annually unless the corporation owns a group annuity for its employees, and each employee receives a
certificate of participation.
Settlement Options
Settlement Options - death benefit spread evenly over income period (averaged). Interest payments in excess of death benefit
portion are taxable.
Estate Tax
Estate Tax - If the insured owns the policy, it will be included for estate tax purposes. If the policy is given away (possibly to a trust)
and the insured dies within 3 years of the gift, the death benefit will be included in the estate.
*FIFO method applies to Life insurance only. The policyowner will receive their investment in the contract first before receiving any
gains in the policy (or being taxed on those gains). Annuities follow a LIFO format.
C. Taxation of Individual Retirement Accounts (IRAs)
1. Traditional IRAs
Contributions, Deductible Amounts, and Distributions
Thetfollowing taxation rules apply to contributions made to traditional IA plans:
• Tax-deductible contributions for the year of the contribution (based on the person’s income);
• Contributions must be made in “cash” in order to be tax deductible (the term cash includes any form of money, such as cash,
check, or money order);
• Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA; and
• Tax-deferred earnings (the money that accumulates in the account) are not taxed until withdrawn.
A distribution from an IRA is subject to income taxation in the year the withdrawal is made. In case of an early distribution (prior to age
59½), a 10% penalty will also apply.
There are certain conditions, under which the 10% penalty for early withdrawals would not apply (penalty tax exceptions):
• Participant is age 59½;
• Participant is totally disabled;
• The money is used to make the down payment on a home (not to exceed $10,000, and usually for first-time homebuyers);
• Withdrawals are for post-secondary education expenses; and
• Withdrawals are for catastrophic medical expenses, or upon death.
Amounts Received by Beneficiary
If the owner dies before distributions have begun, the entire interest must be distributed in full on or before December 31 of the
calendar year of the 5th anniversary of the owner’s death, unless the owner named a beneficiary.
Amounts Received by Beneficiary
Amounts Received by Beneficiary
If the owner dies before distributions have begun, the entire interest must be distributed in full on or before December 31 of the
calendar year of the 5th anniversary of the owner’s death, unless the owner named a beneficiary.
Spouses who are the sole designated beneficiary can do the following:
• Treat an IRA as their own:
• Base the required minimum distribution (RMD) on their own current age;
• Base the required minimum distribution on the decedent’s age at death, reducing the distribution period by one each year; or
• Withdraw the entire account balance by the end of the 5th year following the account owner’s death, if the account owner died
before the required beginning date. If the account owner died before the required beginning date, the surviving spouse can wait
*until the owner would have turned 72 to begin receiving MDs.
Individual beneficiaries other than a spouse must withdraw the entire amount from the account within 10 years of the account
owner’s death. Non-spouse beneficiaries are not permitted to treat an inherited IRA as if it were their own: they are specifically not
allowed to make contributions to the IRA or to roll over any amounts into or out of the inherited IRA.
Like the original owner, the beneficiary generally will not owe tax on the assets in the IRA until they receive distributions from it.
Roth IRAs
Roth IRAs
The following taxation rules apply to Roth IRAs:
• Contributions are not tax deductible: and
• Excess contributions are subject to a 6% tax penalty.
Rollovers and Transfers (IRAs and Qualified Plans)
Rollovers and Transfers (IRAs and Qualified Plans)
Situations exist in which a person may choose to move the monies from one qualified retirement plan to another qualified retirement
plan. However, benefits that are withdrawn from any qualified retirement plan are taxable the year in which they are received if the
money is not moved properly. There are 2 ways to accomplish this: a rollover and a transfer from one account to another.
A rollover is a tax-free distribution of cash from one retirement plan to another. Generally, IA rollovers must be completed within 60
days from the time the money is taken out of the first plan. If the distribution from the first plan is paid directly to the participant, 20%
of the distribution must be withheld by the payor. The 20% withholding of funds can be avoided if the distribution is made airectly
from the first plan to the trustee or administrator/custodian of the new IRA plan. This is known as direct rollover.
The term transfer (or direct transfer) refers to a tax-free transfer of funds from one retirement program to a traditional IRA or a
transfer of interest in a traditional IA from one trustee directly to another.
