Insurance: Chapter 7

Question 1

What is the taxation of whole life insurance?

Answer 1

The cash value above the cost basis at the time of surrender is taxed as ordinary income

Question 2

What ways can dividends be used from a whole life insurance policy?

Answer 2

1. Received as cash
2. Used to reduce the next premium due
3. Used to buy additional paid-up additions (death benefit)

Question 3

What is the death benefit equal to when the insured dies?

Answer 3

The policy face amount plus the paid up additions

Question 4

What is the surrender value equal to if the policy is surrendered?

Answer 4

The cash value plus the cash value of the paid up additions

Question 5

If you take a loan against the policy but also buy a one year term option, what would the resulting death benefits be?

Answer 5

The policy death benefit would be reduced by the amount of the loan.
The entire death benefit would be the policy death benefit plus the amount of the one year term option.

*One year term options only buys term insurance up to the pre-loan cash value of the whole life insurance policy, not including the paid up additions cash value.

Question 6

How are dividends from Whole Life Insurance taxed?

Answer 6

They are typically not taxed and are generally treated as return of unused premium.

Question 7

How are withdrawals and loans against a life insurance policy taxed?

Answer 7

They do not count as taxable income unless the policy is surrendered or lapses and the amount owed exceeds what was paid in.

Insurance pays cash value - loan amount.
Taxable amount is
Cash value - [premiums paid (or billed) - dividends reducing premium]

Question 8

How are death benefits to beneficiary taxed?

Answer 8

Generally income tax free, although exception may apply under the transfer-for-value rule)

Question 9

What is the Uniform Simultaneous Death Act (USDA)?

Answer 9

A rule that any persons who dies within 120 hours of each other predecease each other, meaning that their property does not transfer to the others estate, instead it bypasses the other deceased person and goes to the person(s) who survive both. Keeping each estate separate instead of commingling them

Question 10

Name both characteristics must a life insurance contract have to be classified as a modified endowment contract (MECs)?

Answer 10

1. It is entered into on or after June 21, 1988
2. Fails to meet the seven pay test

If it meets both it is taxed like an annuity

Question 11

Which one of the two tests must a policy meet to classify under the internal revenue code as a life insurance contract for income tax purposes?

Answer 11

1. Cash value accumulation test
2. Guideline premium and corridor test

Question 12

Which act eliminated most of the sales of single premium life insurance contracts known as the Act of 1984?

Answer 12

The Act of 1988

Question 13

How are distributions taxed under MECs?

Answer 13

1. Taxed under the interest first rule
2. If distribution is received before age 59.5 and is not part of annuitized distribution, it
   is subject to 10% federal penalty tax
3. Death benefit excludable from income
4. Dividends paid by mutual life insurance that are received in cash, reduced premiums due or retained by the insurer in repayment of a policy loan

Question 14

A single premium policy issued after 1988 is always a what?

Answer 14

Modified Endowment Contract (MEC)

Question 15

What policies fail the 7-pay test?

Answer 15

Policies fail because they have paid excess premiums within the first 7 years, they are classified as MECs. MECs are single premium policies meaning all premiums are paid at once.

Question 16

During a 7 year period can a purchaser pay more than the net level premium without classifying the policy as a MEC?

Answer 16

Yes. If the client pays less than the net level premium for any year there is a make-up provision that allows them to pay more in the following year. However it does not work inversely, they can’t pay more in one year to pay less the following year

Question 17

Can a policy that passes the 7-pay test when issued later become a MEC?

Answer 17

Yes, if there is material change in the policy. A material change is any increase in the death benefit under the contract

Question 18

Can contracts issued before June 1988 and the death benefit increases after 1988 lose their grandfathered life insurance rules?

Answer 18

Yes in these two scenarios.

1. If DB increases by more the $150k, it becomes subject to material change
2. If policy DB is increased or an additional qualified benefit is purchased and contract
   owner did not have the right to obtain such an increase or addition without providing
   additional evidence of insurability

Question 19

What is the rule for Transfer of Value for life insurance death proceeds to the beneficiary?

Answer 19

If a policy is transferred from one owner to another for valuable consideration, typically but not always money, the income tax exclusion is lost.

ie - husband purchasing his wife’s policy from corporation or transferring a policy to a family member or irrevocable trust

Question 20

What policy transfers are not jeopardized by the transfer of value rule?

Answer 20

1. Transfer to the insured
2. Transfer to a partner of the insured (partnerships)
3. Transfer to a corporation that the insured is a shareholder or an officer
4. Transfer pursuant to a divorce agreement

Question 21

In a 3 person business if owner A has a policy on owners B and C for $100k each, but owner A dies, what should owners B and C do to maintain an even business interest to policy ratio?

Answer 21

Owner B should buy the policy that owner A took out on them.
Owner C should buy the policy that owner A took out on them.
They should purchase owner A’s interest in the business.

Question 22

What is the difference between a gift and a sale for transfer of policies to spouses or children?

Answer 22

A gift causes a taxable gift but not a transfer for value.
A sale is not a taxable gift but causes a transfer for value.

Question 23

What are section 1035 exchanges?

Answer 23

A tax free exchange or life insurance or annuities

Question 24

What exchanges classify as a 1035 exchange?

Answer 24

1. Exchange of life insurance policy for another life insurance policy
2. Exchange of an annuity contract for another annuity contract
3. Exchange of a life insurance policy for an annuity contract
4. Exchange from life insurance policy or annuity contract to qualified long term care
   policies

Question 25

What must be the same on 1035 exchange of life insurance?

Answer 25

1. Same owner
2. Same insured

Question 26

What must be the same on a 1035 exchange of an annuity?

Answer 26

1. Same name of the owner
2. Same name of the annuitant