Life Insurance & Annuities

Question 1

What is a life insurance contract under Int Rev Code 7702?

Answer 1

If contract fails to meet that definition, must include in gross income the “income on contract.”

Try to get a letter from the insurance company stating that it is an insurance product.

Question 2

Are premium payments tax deductible?

Answer 2

No

Question 3

What is whole life insurance?

Answer 3

General term that refers to any permanent insurance - usually ordinary or universal.

Question 4

What is straight term insurance?

Answer 4

Pure mortality cost and builds no cash value.

Question 5

What is convertible term?

Answer 5

Is a straight term insurance that can be converted to whole life at any point without proof of insurability.

Question 6

Are life insurance death proceeds subject to income tax?

Answer 6

Generally free from all income taxes, state and federal.

Question 7

Are life insurance death proceeds includable in FET?

Answer 7

Gross estate shall include value of life estate received by executor AND of a policy with respect a decedent possessed at his death any incidents of ownership.

Question 8

What the tax consequences of a whole life policy cash value?

Answer 8

Cash value in whole life policies accumulate on a tax deferred basis. Upon surrender, all excess cash value gain over basis is taxed as ordinary income to the POLICY Owner.

This is the original tax shelter.
Good to die with; but if cash in, it’s ordinary income.

Question 9

How are withdrawals from an insurance contract taxed?

Answer 9

Withdrawals are generally treated as basis first to come out first (no gain); interest (gain), second. Exception: Modified Endowment Contract “MEC”

Question 10

What are viatical (or lifetime) settlements?

Answer 10

Viatical settlements are amounts received under a life insurance contract on the life of an insured who is a terminally or chronically ill individual. The sick person gets cash immediately (for less than death benefit) and buyer gets possibility of a better return. The sick person has to have a life expectancy of 2 years or less.

Question 11

What is a Modified Endowment Contract “MEC” insurance?

Answer 11

On this one, income is first out (gain) and basis is second out (no gain).

This creates significant income tax issues.

Avoid having life insurance contract deemed a MEC contract

Question 12

What is Code Section 6050-Y?

Answer 12

Code Section 6050-Y: Requires reporting in the case of “reportable policy sales” and the payment of death benefits in the case of policies transferred in a reportable policy sale.

Question 13

What is a “reportable policy sale” for insurance?

Answer 13

An acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from an interest in the contract.

Question 14

What is a SLAT?

Answer 14

Spousal Lifetime Access Trust. Another name for an ILIT.

Question 15

Can there be three parties to an insurance contract?

Answer 15

There cannot be three (3) parties to an insurance
contract, otherwise the death benefit is deemed a taxable gift from the owner to the beneficiaries.

If a beneficiary transfers the beneficial interest, it’s treated as a gift.

Question 16

Can you do a like-kind exchange with life insurance?

Answer 16

Yes, this is possible with no gain.

No gain in loss shall be recognized on certain exchanges of insurance policies.

Question 17

What is the “ transfer-for-value-rule”?

Answer 17

This is an exception to the general rule regarding the income tax-free receipt for death benefits.

If the life insurance policy has been transferred for a valuable consideration the entire death benefit, less cost basis, is taxable income to the transferee.

Question 18

What are the exceptions to the transfer for value rule?

Answer 18

For transfers to:

a. The insured
b. A partner of the insured
c. A partnership in which the insured is a partner, or
d. A corporation in which the insured is a shareholder or officer.

For policies issued after August 17, 2006 Int. Rev. Code§ 101 (j) requires employer-owned life insurance contracts to have a signed notice and consent and annually file Form 8925 in order to qualify for exceptions to the general rule under this code section.

Failure to comply with the requirements will cause the death benefit to be taxed as ordinary income to the corporation.

Question 19

How are life insurance policies valued for transfer purposes?

Answer 19

Multiple ways to value, some require formal appraisal.

Question 20

How are annuities different from life insurance?

Answer 20

One major difference between annuities and life insurance is the tax­-deferred income is taxable at the owner’s or annuitant’s death, unlike life insurance, where the gain in the policy escapes income taxation.

They are just deferred taxable income.

When the payment comes out of the annuity, they pay ordinary income tax on all untaxed dollars (so, on the earnings if pre-tax dollars funded the annuity; or all of payments if it was funded in a qualified account)

Question 21

Who must own a tax-deferred annuity?

Answer 21

A natural person. In the case of an annuity held by a natural person, income is generally not subject to income tax unless distributed. A revocable trust, since it typically is a grantor trust, would be treated as a natural person. Entities such as corporations are by their nature non-natural persons and are not allowed the same tax-deferred advantages as individuals.

Exceptions to company holding:

a. Annuities held by a qualified retirement plan or Individual Retirement Account (“IRA”);
b. Annuities used to fund structured settlements or periodic payments for damages;
c. Immediate annuities;
d. Annuities received by a decedent’s estate by reason of the death of the decedent;
e. Annuities purchases by an employer on termination of a qualified plan.

Question 22

Are the earnings in an annuity taxable?

Answer 22

Yes

Question 23

If a client wants to transfer or surrender an annuity, how is it taxed?

Answer 23

Generally, the partial surrender of an annuity is taxed under the interest first rule, first from interest portion, then principal.

Question 24

What happens when a gift is made of a deferred annuity?

Answer 24

The gain inside the annuity is taxable to the donor.