Sec.2 - Ch.7 - Income Taxation of Life Insurance

Question 1

Cash value above _____ ____ at the time of ____ is taxed as _______ ________

Answer 1

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

Question 2

Are are dividends taxed in a whole life policy?

Answer 2

Dividends paid are generally treated as a return of unused premium and are not income taxable with the exception of dividends from MEC’s

Question 3

How are loans and withdrawals taxed in a whole life policy?

Answer 3

Withdrawals/loans against a insurance policy do not count as taxable income unless the policy is surrendered or lapses and the amount owed exceeds what was paid in - then the loan becomes a taxable event

Question 4

What are the taxes when a whole life policy is surrenderred?

Answer 4

The taxable amount is the cash value less the basis
- Basis = premiums paid - dividends received
- Then that amount is taxed as ordinary income (not capital gains)

Question 5

How are Death benefits taxed?

Answer 5

Death benefits are typically income tax free to the beneficiary

Question 6

What tests must an insurance policy pass to qualify as NOT an MEC (just a regular life insurance contract)?

Answer 6

• The cash value accumulation test or the guideline premium and corridor test

Question 7

What 2 things automatically qualify a life insurance contract as a MCE?

Answer 7

• Entered into the contract on or after June 21, 1988
• Fails to meet the “seven pay test”
  **All single premium policies issued after 1988 are always a MCE’s

Question 8

How are MEC’s distributions taxed (dividends, death benefit, and distributions)? What is it similar to?

Answer 8

• They are similar to taxation of a deferred annuity
• Distributions are taxed under the “interest-first” rule (LIFO)
• If a taxable distribution, which is not part of an annuitized distribution, is received under the contract before age 59 1/2 and the policyholder is not disabled, it is subject to a 10% federal penalty tax
• The death benefit is excludable from income
• Dividends paid by mutual life insurance companies under MEC are taxable as income if they are used as follows:
  
  • If they are received in cash or to reduce premiums due
  • If they are retained by the insurer in repayment of a policy loan

Question 9

What does it mean to fail the 7-pay test?

Answer 9

When excess premiums have been paid within the first 7 years
- This classifies them as a MEC

Question 10

What is a material change in a life insurance policy?
Can this change the policy into a MEC?

Answer 10

• Material Change: Any increase in the death benefit under the contract
• If the death benefit increases by more than $150,000, the contract becomes subject to material change and may become a MEC (a change to $150,000 even does not qualify it)

Question 11

What happens if proof or insurability is not presented when trying to increase the contract benefit amount?

Answer 11

The contract could lose the grandfathered status and become a MEC

Question 12

Can you deduct interest on a life insurance policy loan?

Answer 12

Not anymore