Tax 6-1 & 2 Life Insurance Flashcards
Life Insurance
The life insurance industry has, over the years, moved away from pure insurance protection and has structured whole life policies more like investment vehicles. However, the tax treatment of life insurance is considerably different than the tax treatment of investments. During the policy owner’s lifetime, the accumulation of cash value within the policy is allowed to grow tax deferred until surrender. This is commonly referred to as the _____ buildup.
(6-1,2, pg 9)
inside
At the death of the insured, the life insurance proceeds are excluded from the gross income of the beneficiary. An investment product does not share these tax advantages.
Life Insurance
In 1984 Congress adopted two tests, only one of which must be met for a product to be considered life insurance. These tests are known as (1) the cash value accumulation test and (2) the cash guideline premium and corridor test. The policy must meet at least one of these tests. While the mechanics of these tests are not important for our purposes, it should be noted that if the policy fails to meet ONE OR BOTH of the tests, the cash value part of the policy will be taxable to the owner currently.
(6-1,2, pg 9)
both
In other words, there is no tax deferral on the annual increase in the cash surrender value.
Life Insurance
Presuming that the definitional provisions of the Tax Reform Act of 1984 have been met, income earned on money invested in insurance accumulates tax _____. If one invests in securities, dividends and interest are currently taxable, as are any realized gains.
(6-1,2, pg 9)
deferred
Thus, because of the tax shelter nature of life insurance, what may appear to be a relatively low rate of return on a policy may indeed be much better than it seems.
Life Insurance
The investment growth of a life insurance policy may not, however, be completely free of income tax. Proceeds payable before death (i.e., the surrender value) may be taxable if they exceed the insured’s _____ (the investment in the contract). In other words, to the extent that the cash surrender value exceeds the investment in the contract, there is taxable income at the surrender of the policy.
(6-1,2, pg 10)
cost
If these proceeds are received in a lump-sum payout, the excess over this cost is taxable as ordinary income (interest income) in that year. If the proceeds are spread out in payments over a fixed period of years, the insured’s cost is prorated over this period, with those amounts received in excess of cost taxed in the year of receipt (just like an annuity).
Life Insurance
On the insured’s death, the proceeds, if paid in a _____ sum to the beneficiary, are exempt from income tax under IRC Section 101. Payments made under other settlement options may be partially taxable.
(6-1,2, pg 10)
lump
For example, interest on proceeds left with the insurance company is taxable to the beneficiary when paid or credited. Likewise, proceeds paid out in installments may be taxable to the beneficiary to the extent the anticipated installments exceed the exempt proceeds.
Life Insurance
An exception to the general rule excluding life insurance proceeds from income is the transfer for _____ rule. This rule can actually render a portion of the death benefit of a life insurance policy as includible in income. This rule applies when a life insurance contract is transferred for valuable consideration.
(6-1,2, pg 10)
value
A calculation is necessary to determine the amount of proceeds excludible from income. The amount of the death benefit that is excludible is the actual value of the consideration paid by the transferee to acquire the contract (or the interest in the contract), plus any premiums or other amounts paid by the transferee subsequent to the transfer.
Life Insurance
Two exceptions to the transfer for value rule may apply. None of the proceeds will be includible as income if the transferee’s basis in the contract is determined in whole or in part by reference to the transferor’s basis. If, for example, a policy is transferred from one corporation to another in a tax-free reorganization, or the policy is transferred between _____, then the exclusion for the death benefit still applies.
(6-1,2, pg 11)
spouses
The other exception to the transfer for value rule occurs if the transfer is to the insured, the insured’s partner or partnership, or a corporation in which the insured is a shareholder or officer.
Life Insurance
Section _____ of the Internal Revenue Code governs the tax treatment on the exchange of one insurance product for another. The rule specifically states that no gain or loss shall be recognized on the exchange of one life insurance contract for another life insurance contract, annuity, or endowment contract.
(6-1,2, pg 11)
1035
Tax free exchange treatment also applies to the exchange of an endowment contract for an annuity or another endowment contract providing for payments that start no later than the beginning date under the old contract. This rule also applies to the exchange of an annuity contract for another annuity contract.
Life Insurance
Single premium life insurance begins with one payment, typically of at least $_, _ _ _ and usually not more than $1 million. Under the terms of most policies,
there are no further payments. The money may be applied to a whole life, universal, or a variable life policy.
(6-1,2, pg 11)
$5,000
Life Insurance
Modified Endowment Contract
A modified endowment contract is a life insurance contract that meets both the state law definition and the Internal Revenue Code definition of a life insurance contract, and fails the so-called “_____-pay test.” Generally, single premium contracts enjoy tax-deferred accumulation inside the contract just like any other life insurance product.
(6-1,2, pg 12)
seven-pay test
If a policyholder wishes to make a withdrawal (or loan) from that modified endowment contract before age 59½, however, that withdrawal (or loan) will be treated just like a withdrawal from an annuity contract.
Life Insurance
Modified Endowment Contract
A withdrawal from a modified endowment contracts is considered accumulation first (taxed as ordinary income) and then basis (LIFO—last-in, first-out), and the taxable portion carries an additional _ _% IRS penalty on the taxable portion of the distribution. This means that distributions (primarily withdrawals or loans) will be treated on a LIFO basis; therefore, proceeds from distributions will be taxed first as ordinary income to the extent that the cash surrender value exceeds the investment in the contract.
(6-1,2, pg 12)
10
Further, if the policyholder withdraws more than the earnings within the contract, then the distribution begins eating into the basis, and the basis in the contract will be
reduced. This will affect the taxation of future withdrawals or loans, if any. Distributions are withdrawals, loans taken as cash or used to pay premiums, and dividends received as cash or used to pay a loan.
Life Insurance
Modified Endowment Contract
Distributions do not include dividends retained by the insurer to pay premiums or to purchase paid-up insurance or other benefits. Also not treated as distributions are assignments or pledges of any part of the contract if they are used to cover burial expenses, or if the face amount is less than $_ _, _ _ _.
$10,000
$25,000
$50,000
(6-1,2, pg 13)
$25,000
Life Insurance
Modified Endowment Contract
A policy will be designated a modified endowment contract if it fails to meet the “_____-pay test.” The test is failed if the cumulative amount paid under the contract at any time in the first seven years is greater than the seven net level annual premiums that would have been paid under a seven-pay, paid-up contract. If this is the case, then the contract is considered a modified endowment contract.
(6-1,2, pg 11)
seven-pay test
The effective date applies to all contracts issued or contracts that have been materially changed on or after June 21, 1988. Note: Any single-premium whole life policy issued on or after June 21, 1988, is a modified endowment contract. This rule also will apply if a distribution is kept by the insurance company to pay premiums. Further, all modified endowment contracts issued by the same company to the same policyholder during a calendar year will be treated as one contract.
Life Insurance
Modified Endowment Contract
An early withdrawal penalty of 10% also will typically be imposed on the taxable portion of a distribution made before the policyholder is age __. The penalty will not apply if the policyholder meets one of the exceptions to the premature distribution penalty—for example, he or she is disabled or the distribution is annuitized over the life of the policyholder or the joint lives of the policyholder and a beneficiary.
(6-1,2, pg 11)
59½
Under the aggregate policy rule, all contracts issued to the policyholder by the same insurance company within a calendar year will be considered one contract for determining the applicability of the test. Expense charges will not be taken into account in determining the seven-pay premiums (except for contracts with face amounts less than $10,000, in which case $75 per year can be added). During the first seven years of the contract, the rules will apply only to those distributions that occur during the year the contract fails to meet the seven-pay test and all subsequent years.
Life Insurance
Modified Endowment Contract
Whether a contract was issued before or after June 22, 1988, material changes would include the following:
(6-1,2, pg 14)
the exchange of one policy for another
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 $150,000 over the death benefit payable as of October 20, 1988 (unless the contract would have met the seven-pay test on June 21, 1988)
