Module 2: Investment Vehicle Taxation, NII, Additional Medicare Tax and Education Planning Flashcards
Two tests for Life Insurance (only one must be met)
1 - The Cash value accumulation test
2 - The Cash Guideline Premium and Corridor Test
When can a life insurance policies cash value be taxable?
Surrenders that exceed the insured’s cost basis, otherwise they’re considered a return of principal.
Taxation of Cash Value Surrender Above Cost Basis
Ordinary Income
Distribution of Life Insurance Taxation
FIFO - gains paid out last
Life Insurance in Qualified Plans
The purchase of life insurance must be incidental to providing a retirement benefit. The premiums paid are taxable to the employee.
Transfer for Value for Life Insurance Contract
This rule applies when a life insurance contract is transferred for valuable consideration. A calculation is necessary to determine the amount of proceeds excludible from income.
- Typically it’s the DB minus amount paid for DB plus any premiums or other amounts paid by the receiver of the insurance contract
Exceptions to the Transfer for Value Rule (5)
- Sale of the policy is to the insured, insured spouse, or insured’s ex-spouse if incidental to a divorce
- Sale to a business partner of the insured
- Sale to a partnership in which the insured is a partner
- Sale to a corporation in which the insured is a shareholder or officer
- Sale to anyone whose basis is determined by reference to the original transferor’s basis (gift or swap
1035 Exchange for Life Insurance
No gain or loss shall be recognized on the exchange of one life insurance contract for another life insurance contract, annuity, or endowment contract.
Single Premium Life INsurance
Pre- june 21 1988 - would be able to take tax free loans off the policy, but if the policy lapsed or was terminated before death then taxes would be owed on the total amount that was withdrawn. If held till death, the rest of the policy is passed along tax free
Modified Endowment Contract (MEC)
A life insurance contract that meets both the state law definition and IRC definition of a life insurance contract, AND fails the seven pay test.
Seven-Pay Test
Assumes a step process over the first seven years of the cash value life insurance contract.
MEC Taxation
If a policyholder wishes to make a withdrawal or loan from an MEC before 59.5 then it will be treated just like a withdrawal from an annuity contract with LIFO treatment at ordinary income
- There may also be a 10% premature distribution penalty on the taxable portion of the distribution
- Taking dividends in cash or electing to use whole life dividends to offset an outstanding loan is a taxable event.
- Electing to use dividends to buy paid-up additions could defer taxation on the MEC dividends, and could even eliminate the tax liability upon the death of the insured.
MEC Testing for Material Change
Policies can be tested for MEC even after its first seven years, if there is a material change to the benefits provided by the policy. Once a change occurs, a new seven-year testing period is started.
Life Insurance Material Changes (6)
- The exchange of one policy for another
- An exchange of insured
- The increase or addition of certain riders
- The conversion of a term policy for a whole life contract
- An increase in future benefits (unless the increase is due to the payment of premiums to fund the lowest death benefit or due to the crediting of interest to those premiums)
- An increase of more than 150k over the death benefit payable as of Oct. 20 1988
Life Insurance non-material changes
- a decrease in future benefits
- an increase in death benefits because of dividends
- a COLA to the death benefit
Exclusion Ratio for Annuities Definition
Annuity Payments or periodic payments from a commercial annuity are partially a return of capital and partially interest income
Exclusion Ratio Equation (Fixed Annuities)
Investment in Contract / Total Expected Return * annual return each year
Example:
- Find expected return: dollars per month * 12 * life expectancy years left
- Plug into the equation
The amount included in taxation for annuities, how is it taxed?
Ordinary Income
Variable Annuity Exclusion Ratio Definition
The exclusion amount is determined by dividing the investment in the contract by the number of expected payments.
Example:
- Find number of estimated payments: 12 months * expected years of life
- Take initial investment / anticipated payments
Partial Annuitization (non-qualified annuities only)
If any portion of an annuity contract is received for 10+ years or over multiple lives, that portion of the annuity will be treated as a separate contract for annuity taxation purposes. Holders can elect to receive a portion of an annuity contract and leave the remained of the contract to accumulate income on a tax-deferred basis.
Tax Treatment of Nonperiodic Distributions
- Before Annuity Date - pre 1982 FIFO, post 1982 LIFO
- After Annuity Start Date - Generally fully taxable to the extent that the withdrawal exceeds the investment cost remaining in the contract.
- May also have a premature distribution penalty of 10%
Computing Taxpayer Holding Period for Securities
The day of the acquisition is not counted by the day of disposition is. The holding period computed is based on calendar months, not days.
Taxation of Property Acquired by Gift
Tacked - Where the recipient of a gift assumes the donor’s adjusted basis, so their holding period begins on the date that the donor acquired the property.
Non-tacked - if the FMV on the date of the gift is used as the donee’s basis, the holding period starts on the date of the gift.
** It seems that it’s dependent on the FMV at the time of the gift, if it’s less than the basis, we use the nontacked method. It it’s more at the time of the gift, we use the ‘tacked’ method.
Taxation of Property Acquired by a Decedent
- Holding period - deemed to be long-term and the cost basis resets to the DOD.
Inherited IRA Strategy for Non-Spouse
If they have other earned income in the budget, they could contribute money to an IRA in their own name to offset the income from the 10 year period
Other Inherited IRA Rules
If the beneficiary is not 10 years younger than the deceased, they can still do the lifetime RMD’s.
- A minor child who has inherited an IRA is not subject to the 10 year rule until they turn 18.
Capital Asset Excluded Classes (7)
- Inventory or property held primarily for sale to customers in the ordinary course of business
- Property subject to depreciation and real property used in a trade or business
- A copyright; literary or artistic composition, a letter, memo, or similar property held by the author or creator, or by the donee of the author or creator
- A patent, invention, model or design; IP
- Accounts or notes receivable, acquired in the ordinary course of business, for services rendered or from the sale of inventory
- United States Goverrnment publications
- Supplies regularly used or consumed by the taxpayer in the ordinary course of a trade or business
When is a Capital Loss Deductible
- Generally, a capital loss is only deductible on the sale of an asset held for investment purposes. So the sale of an automobile can result in a gain, but if it was for personal use it cannot result in a loss.
Capital Gains Calculation
- Wage income - deduction + LTCG = income for capital gains rate. Marginal tax rates apply, not all of the capital gain is taxed at the marginal rate, it’s taxed in it’s specific rate.
What is considered 1250 Property (Collectibles)?
- Collectibles (if held more than 1 year)
- Gold and Silver ETF’s
Long-term capital gains rates for 1250 Property
- Maximum of 28% rather than the lower LTCG rates applied to securities
Mutual Fund Basis
- Specific Identification
- Average Cost
- FIFO
Specific Identification Method
- Requires the seller of the shares to identify shares of the fund that are sold.
Average Cost Method
- The investor pools all purchased shares into one account and then divides the total cost of all their shares by the number of shares held. This is only available for mutual fund shares