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LIFE INSURANCE (OFFICIAL LLQP) > TAXATION OF LIFE INSURANCE & TAX STRATEGIES (Chapter 7) > Flashcards

TAXATION OF LIFE INSURANCE & TAX STRATEGIES (Chapter 7) Flashcards

1
Q

REVIEW

What is a family coverage rider?

A
  • Rider for policyholders who have a spouse and children.
  • They’re sold in units that cover all eligible family members. (Ex. a unit might provide coverage of $5,000 for the spouse and $1,000 for each child.)
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2
Q

Life Insurance Terminology

Adjusted Cost Basis (ACB)

A

The amount of money invested.

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3
Q

REVIEW

How do you calculate the Net Amount at Risk ?

A

Death Benefit – Investment Account Value

(ex. Pratik owns a UL policy with a death benefit of $500,000 and an account
value of $128,000. The current NAAR of his policy is $372,000, calculated as
($500,000 – $128,000).

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4
Q

Life Insurance Terminology

Deemed Disposition

A

When the policyholder gives up all ownership rights to the policy, by selling or surrendering the policy.

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5
Q

REVIEW

What are the differences in mortality deductions and expenses with UL policy and Whole Life?

A
  • Mortality deductions and expenses
    are deducted from investment account in UL. Mortality deductions may be based on YRT or LCOI costing.
  • Mortality deductions and expenses
    are taken from policy reserves in Whole Life.
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6
Q

REVIEW

Life Expectancy

A

Average number of years that a person can expect to live from that age forward.

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7
Q

Life Insurance Terminology

Cash Surrender Value (CSV)

A

The amount that the insurance company will pay to the policyholder if the policyholder surrenders the contract.

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8
Q

REVIEW

What are THREE ADVANTAGES of term insurance?

A
  1. Premiums are guaranteed over the term.
  2. Renewable and convertible provisions can be used to extend coverage.
  3. Term of coverage can be customized to meet a specific need.
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9
Q

REVIEW

Simplify Limited Payment Whole Life

A

Non-forfeiture option that provides lifelong coverage, while only requiring premiums for a specified guaranteed period of time.

(e.g., Hamish bought a 25-pay life policy on his own life when he was 45 years old. He only has to pay premiums for 25 years, at which point he will be 70 years old. However, the coverage will continue be past age 70, right up until his death.)

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10
Q

Chapter 7

What is Taxation of life insurance?

A

Using life insurance to manage taxes that may arise upon death or as a result of a deemed disposition.

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11
Q

Name some common situations of a deemed disposition in a life insurance policy

A
  • Policyholder surrenders all or a part of the policy;
  • Policyholder withdraws cash from the policy;
  • Policyholder takes out a policy loan;
  • Participating policy pays out dividends;
  • Policy becomes non-exempt;
  • Policyholder absolutely assigns or transfers ownership of the policy to another party;
  • Policyholder dies and is not the life insured, such that ownership of the policy is transferred to
    another party.
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12
Q

What is a policy gain?

A

Disposition of all or a portion of his interest in a life insurance policy.

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13
Q

What are the calculations for a policy gain?

A

Policy gain = proceeds of disposition – adjusted cost basis (ACB)

(e.g., Brian surrendered his whole life insurance policy and received proceeds of $46,000. The insurance company advised him that his adjusted cost basis (ACB) was $20,000, so he had a policy gain of $26,000 and 100% of this was taxable. Policy gain = $46,000 – $20,000 = $26,000

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14
Q

TRUE OR FALSE?

There are three ways to calculate a policy’s ACB, depending on when the policy was last acquired.

A

TRUE

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15
Q

What is ”Last Acquired” ?

A
  • Last acquired means the latest of the following dates:
  • When the policy was first purchased;
  • When ownership of the policy was transferred to the current policyholder;
  • When coverage under the policy was last modified or reinstated.
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16
Q

Life Insurance Terminology

Exempt vs Non-Exempt Policies

A
  • Non-exempt policies are subject to annual accrual taxation.
  • If an insurance policy is an exempt policy, the policy’s investment account can grow on a tax-deferred or tax-free basis.
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17
Q

Life Insurance Terminology

Fair Market Value (FMV)

A

Fair market value (FMV) is an asset’s estimated value if it were sold today in the current market.

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18
Q

Policies can be categorized in three groups for tax purposes, what are they?

A
  • Group 1 (G1)
  • Group 2 (G2)
  • Group 3 (G3)
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19
Q

Explain G1 Policies

A

Policies acquired prior to December 2, 1982 and that have not been transferred to another policyholder or been modified since that time.

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20
Q

Explain G2 Policies

A

Policies acquired after December 1, 1982 but before January 1, 2017

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21
Q

Explain G3 Policies

A

Group 3 (G3) policies are those that were issued after December 31, 2016, or previously G2 policies that have lost their status.

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22
Q

TRUE OR FALSE?

A G1 policy will lose its status and become a G2 policy if ownership is transferred to another policyholder or if coverage is modified.

A

TRUE

G1 policies provide some significant tax
advantages, agents should be careful about changing this status.

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23
Q

TRUE OR FALSE?

A G2 policy will lose its status and become a G3 policy if it is converted to another type of policy on or after December 2nd, 1982.

A

FALSE

  • A G2 policy will lose its status and become a G3 policy if it is converted to another type of policy on or after January 1, 2017.

For example, a term policy that was issued in 2015 but that is converted
to a permanent policy in May 2022 will be a G3 policy from that point forward.

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24
Q

TRUE OR FALSE?

A G2 policy can also lose its status and become a G3 policy if any coverage that requires medical underwriting is added to the policy after January 1, 2017

A

TRUE

Some examples include increasing the amount of coverage, adding a term rider to the policy, or substituting the life insured under the policy.

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25
Q

G1 policies are sometimes referred to as?

A

Grandfather policies

26
Q

TRUE OR FALSE?

The ACB calculated under the old method (G1 Policies) are usually lower than the ACB calculated under the methods for G2 or G3 policies

A

FALSE

The ACB calculated under the old method (G1 Policies) will generally be higher than the ACB calculated under the methods for G2 or G3 policies.

[Ref. 7.1.4.2]

27
Q

REVIEW

a policy gain is calculated as…

A

(Proceeds of disposition – ACB)

28
Q

FILL IN THE BLANK

For G2 and G3 policies, the key factors that determine a policy’s ACB are ______________.

a) YRT minus the NCPI
b) NAAR minus the NCPI
c) Death Benefit minus the NAAR
d) Cumulative Premiums minus NCPI

A

For G2 and G3 policies, the key factors that determine a policy’s ACB are the cumulative premiums less the net cost of pure insurance (NCPI)

29
Q

TRUE OR FALSE?

In the early years of a policy, (G2 & G3) the ACB of a policy decreases because the NCPI is more than the premiums.

A

FALSE

In the early years of a policy, the ACB of a policy increases because the NCPI is less than the premiums.

[Ref. 7.1.4.3]

30
Q

Life Insurance Terminology

Net Cost of Pure Insurance (NCPI)

A

A measure of the pure mortality costs under the policy for a given year, and it reflects a combination of the net amount at risk (NAAR) and the mortality risk for the life insured.

31
Q

TRUE OR FALSE?

When the life insured ages, his mortality risk increases to the point where the NCPI exceeds the premiums and the ACB of the policy decreases.

A

TRUE

[Ref. 7.1.4.3 ]

32
Q

Regulations to the Income Tax Act prescribe different methods of calculating both the NCPI and the NAAR for G2 and G3 policies.

These regulations also prescribe the use of updated standardized mortality tables for G3 policies, reflecting increases in life expectancies.

Name one or two of the general result of these changes:

A
  • The NCPI of a G3 policy tends to be lower during the early years of the policy, compared to a G2 policy.
  • The ACB of a G3 policy will tend
    to grow faster in the early years of the policy, compared to a G2 policy.
  • It will take longer for the ACB of a G3 policy to reach zero as the life insured ages.
33
Q

Name a couple factors that affect the Policy’s Adjusted Cost Basis

A
  • Participating Policy Dividend
  • Policy Loans Repayments
  • Withdrawals and partial surrenders
  • Policy gains included in income
34
Q

G2 & G3 Policies

What is the calculation of Adjusted Cost Basis (ACB) for G2 & G3 policies?

A

Cumulative Premiums — NCPI = ACB

35
Q

REVIEW

How do you calculate the policy gain?

G2& G3 Policies

A

Proceeds of disposition— ACB

36
Q

Adjusted Cost Basis Calculations

Last Acquired Polices (G1, G2, G3) (Participating & Non-Participating) before & after December 1st 1982 key points

A

Policies prior to Dec. 2nd 1982 (G1)

(Non-participating)
CSV — Premium = ACB

(Participating Policies)
Premium — Dividends = ACB
—————————————————————-

Policies post Dec. 1st 1982 (G2 & G3)

(Non-Participating)
Premiums — NCPI = ACB

(Participating)
Premiums — NCPI — dividends = ACB

37
Q

Explain Taxation of a full surrender?

A
  • When the policyholder surrenders (cancels or terminates) the policy.
  • A full surrender is considered to be a disposition for tax purposes.

-

38
Q

Life Insurance Terminology

MTR

A

Marginal Tax Rate

39
Q

Life Insurance Terminology

The difference between Death Benefit & Face Amount

A
  • The face amount is the amount of money the insurance company agreed by contract to pay to beneficiaries after an insured person dies.
  • The death benefit amount includes the face amount, but it also includes add-ons, often called riders, that the policyholder included in the original contract.
40
Q

Life Insurance Terminology

Prorated

A

Divided, distributed, or assessed proportionately (as to reflect an amount that is less than the full amount included in an initial arrangement)

41
Q

What are the calculations of a full surrender?

A

CSV — ACB = Policy Gain
($24,00 - $10,00 = $14,000)

Policy Gain x MTR = Tax Payable
(14,000 x 35% = $4,900)

CSV — MTR = After Tax Funds
$24,000 — $4,900 = $19,000

[Ref.7.3.1]

42
Q

What are the calculations for a PARTIAL surrender?

A

CSV = $24,000
ACB = $10,000
FA = $200,000

(Reducing $200,000 to $150,00 for example)

  1. Face Amount — Reduced Coverage / Face amount = Percentage%
    ($200,000 — $150,000 / $200,000 = 25%)
  2. Percentage% x ACB = Prorated ACB
    (25% x $10,000 = $2,500)
  3. Percentage% x CSV = Prorated CSV
    (25% x $24,000 = $6,000)
  4. Prorated CSV — Prorated ACB = Policy Gain
    ($6,000 — $2,500 = $3,500)
  5. Policy Gain x MTR = Tax Payment
    ($3,500 x 35% = $1,225)
  6. Policy Gain — Tax Payment = After Tax Gain
    ($3,500 — $1225 = $2,275)

[Ref.7.4.1]

43
Q

Reducing Coverage

TRUE OR FALSE?

For G2 policies, the policy gain on a partial surrender is calculated on a prorated basis

A

TRUE

For G2 policies, the policy gain on a partial surrender is calculated on a prorated basis, so the CSV and ACB used reflect the reduction in the coverage.

[Ref.7.4.1]

44
Q

Reducing Coverage

TRUE OR FALSE?

For a G3 policy, the policy gain is also calculated on a prorated basis, but in this case the prorating is based on the ratio of the ACB of the policy to the policy’s net cash value

A

TRUE

For a G3 policy, the policy gain is also calculated on a prorated basis, but in this case the prorating is based on the ratio of the ACB of the policy to the policy’s net cash value *(i.e., the CSV minus outstanding policy loans).

45
Q

Reducing Coverage

TRUE OR FALSE?
For G1 policies, prorating is required.

A

FALSE

For G1 policies, no prorating is required. Withdrawals only result in a policy gain once cumulative withdrawals exceed the entire policy’s ACB.

46
Q

What is a policy withdrawal?

A
  • The withdrawal that the policyholder makes from the accumulating fund of a UL policy, even if he does not reduce the coverage
  • A policy withdrawal is also known as a partial surrender
47
Q

What are the calculations for a policy withdrawal?

A

FA = $200,000
ACB = $65,000
CSV = $80,000

  1. Amount withdrawn / CSV x ACB = Prorated ACB
    (($40,000 / $80,000) x $6500) = $32,500
  2. Amount withdrawn — Prorated ACB = Policy Gain
    $40,000 —32,500 = $7500
  3. Policy Gain x MTR = Tax Payable
    $7,500 x 35% = $2,625
  4. Policy Gain — Tax Payable = After Tax Funds
    $7,500 — $2,625 = $2875

[Ref. 7.4.2]

48
Q

TRUE OR FALSE?

If the policyholder takes out a policy loan that is less than the adjusted cost basis (ACB), he will not have a policy gain, but the ACB will be reduced by the amount of the loan.

A

TRUE

If the policyholder takes out a policy loan that is less than the adjusted cost basis (ACB), he will not have a policy gain, but the ACB will be reduced by the amount of the loan.

  • (e.g., If Alicia only took out a policy loan of $4,000, the policy’s ACB would be reduced to $6,000.

New ACB = $10,000 – $4,000 = $6,000

She would not have to report a policy gain)

49
Q

What happens when the policyholder takes out a policy loan that is greater than the policy’s ACB?

A

If a policyholder takes out a policy loan that is greater than the policy’s ACB, he will have a policy gain equal to the amount of the loan, minus the ACB. The ACB of the policy will be reduced to zero.

  • (e.g., Alicia’s ACB is $10,000.

Suppose that she instead takes out a policy loan of $19,000. She would have a policy gain of $9,000 and $3,150 in tax payable.

Policy gain = $19,000 – $10,000 = $9,000
Tax payable = $9,000 × 35%

Her policy would now have an ACB of $0.

50
Q

What happens when you repay a policy loan?

A

If a policyholder repays a policy loan, he will be able to deduct the repayment from his taxable income, up to the amount of the policy gain he had to report when he took out the loan.

If he repays more than this amount, the excess will increase the policy’s ACB.

(e.g., Suppose that Alicia repays $12,000 of her $19,000 policy loan. She would be
able to claim a tax deduction of $9,000, which is the amount of the policy gain
she had to include in her income as a result of the loan.

The ACB of her policy
would increase to $3,000.

ACB calculated as ($12,000 – $9,000)).

51
Q

Does the policy loan have interest?

A

YES

  • When a policyholder takes out a policy loan, the insurance company will charge interest on that loan.
  • If the policyholder invests the loan proceeds for the purpose of earning property or business income, then he can deduct the interest he pays on that loan from his taxable income.
52
Q

What is an exempt life insurance policy?

A

Permanent insurance policy primarily for insurance purposes, rather than investment purposes.

53
Q

Explain Maximum Tax Actuarial Reserve (MTAR) rule

A

Hypothetical policy that serves as a benchmark to project the cash value of the accumulating fund of an exempt test policy.

The projected future values of the accumulating fund cannot exceed the projected MTAR at any time in the future.

54
Q

What is an exempt test, and it’s purpose?

A

Hypothetical rule that prevent taxpayers from taking unfair advantage of the favorable tax treatment of investment income that may be provided within an insurance policy.

55
Q

What are the two exempt test rules?

A
  • Maximum Tax Actuarial Reserve (MTAR) rule
  • Anti-dump-in (250% Rule)
56
Q

TRUE OR FALSE?

G1 policies are subject to the exempt test and annual accrual taxation.

A

FALSE

G1 policies are not subject to the exempt test and are not subject to annual accrual taxation.

[Ref. 7.6.1]

57
Q

Explain the concept of the Maximum Tax Actuarial Reserve (MTAR) rule

A
  • To maintain exempt status.
  • The cash value of a policy’s accumulating fund account cannot exceed the Maximum Tax Actuarial Reserve (MTAR), which is the projected cash value of the accumulating fund of an exempt test policy.
58
Q

FILL IN THE BLANK

If the policy fails the MTAR test on its anniversary, the Income Tax Act allows a grace period of _______ after that date for the problem to be fixed before the policy officially loses its exempt status.

a) 30 days
b) 60 days
c) 90 days
d) 45 days

A

If the policy fails the MTAR test on its anniversary, the Income Tax Act allows a grace period of 60 days after that date for the problem to be fixed before the policy officially loses its exempt status.

59
Q

TRUE OR FALSE?

Once an exempt policy is declared to be non-exempt (i.e., if it cannot be restored during
the 60-day grace period), it remains non-exempt forever.

A

TRUE

60
Q

What are the remedies for a policy to remain its exempt status?

A
  • Increasing the face amount
  • Withdrawing premiums
  • Side funds (Side account)
  • Anti-dump in rule
61
Q

What’s Anti-dump in rule?

A

It’s also known as the 250% rule which prevents the policyholder from making large lump-sum deposits to the policy after its 7th anniversary.

62
Q

How does the Anti-dump in rule apply?

A
  • Beginning on the policy’s 10th anniversary and every anniversary thereafter, the accumulating fund on that anniversary date is compared to the accumulating fund three years previous.
  • The cash value on the 10th anniversary is compared to the cash value on the 7th anniversary; the cash value on the 11th anniversary is compared to the cash value on the 8th anniversary, and so on.
  • If the value of the fund is 250% or more of the value of the fund three years prior, the anti-dump-in provision will apply.

LIFE INSURANCE (OFFICIAL LLQP) (18 decks)

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