UNIT 10

Question 1

INDIVIDUAL LIFE INSURANCE PREMIUMS

Answer 1

premiums paid for individual life insurance are NOT tax deductible.

Question 2

CASH VALUE ACCUMULATIONS

Answer 2

Interest earnings credited to life insurance cash values are tax-deferred– not tax taxable as long as they remain inside the policy.

Question 3

FULL SURRENDERS

Answer 3

When a life insurance policy is surrendered, any gain in the cash value is taxable. The gain is the cash value minus the policy’s cash basis; the sum of all premiums paid. So cash value accumulations are tax deferred, but not necessarily tax-free.

Question 4

WITHDRAWALS OR PARTIAL SURRENDERS

Answer 4

ARE taxable to the extent of any gain. Withdrawals are taxed on a first-in-first -out (FIFO) basis; money withdrawn is considered to come from the premiums paid (cost basis) FIRST and cost basis withdrawals are NOT taxable. The death benefit is reduced by a withdrawal of cash value.

When a withdrawal exceeds the cost basis, the excess IS taxable.
- if the cost basis is $10,000 and a withdrawal is $12,000, $2,000 is considered excess and taxable.

Question 5

POLICY LOANS

Answer 5

Policy loans reduce the cash value of the policy and can be used as collateral for the loan. Policy loans reduce the death benefit; however, loans can be repaid at any time, which restores the cash value and death benefit. Loans are NOT taxable to the policyowner, even if the amount of the loan exceeds the policy’s cash basis. The amount of the loan never becomes taxable even when the insured dies.

Question 6

DIVIDENDS

Answer 6

Are NOT taxable. For tax purposes, they are considered to be a return of the portion of the premium paid for the policy. Since premiums are paid with after-tax dollars, they are not taxed again when they are returned in the form of dividends.

While dividends are not taxable, if they are left to accumulate at interest, the interest IS taxable.

Question 7

DEATH BENEFITS

Answer 7

When the entire death benefit amount—Lump Sum— is paid to a named beneficiary it is NOT taxable as income whether the policy is owned by a business or individual.

IF the death benefit payment is made under other settlement options–not a lump sum– the original death benefit is not taxable, any interest earned on the proceeds are taxable as ordinary income when paid to the beneficiary.

Question 8

ACCELERATED DEATH BENEFITS

Answer 8

Are an advance of death benefits. Written certification from a physician is required, diagnosing a qualifying event that will substantially decrease the insureds life span. Qualified events include terminal illnesses expecting to end in death within 24 months, acute illness, emergency organ transplant, permanent confinement to nursing homes, long term care etc. Part or all of the death benefit may be used.

Accelerated death benefits are tax exempt.

Question 9

BUSINESS LIFE INSURANCE PREMIUMS FOR THE FOLLOWING PURPOSES ARE NOT TAX DEDUCTIBLE TO THE BUSINES

Answer 9

• KEY PERSON LIFE INSURANCE POLICIES
• LIFE INSURANCE POLICIES FUNDING BUY-SELL AGREEMENTS
• LIFE INSURANCE POLCIES THAT WILL REIMBURSE THE COMPANY FOR BEBEFITS PAID UNDER DEFERRED COMPENSATION ARRANGEMENTS.
• these are not considered to be approved business expenses because the business receives financial benefits from owning these polices–.
• Premiums paid for executive bonus plans ARE tax deductible to the business as employee compensation. As such, the amount of the premium is also considered taxable income to the employee. *

Question 10

GROUP LIFE INSURANCE

Answer 10

Group life insurance premiums paid by the employer ARE tax deductible as a business expense provided under an employer group benefit plan.

The premium for the first 50k of coverage is NOT taxable to the employee, premiums for any additional coverage over 50k is taxable as income to the employee.

With contributory plans, the employee portion of the group life insurance premium is not tax deductible.

Question 11

MODIFIED ENDOWMENT CONTRACTS (MECs)

Answer 11

Is a special type if life insurance under federal income tax law. Specifically, the law prescribes a test that is intended to differentiate between policies that are purchased primarily for certain tax advantages, versus policies that are purchased primarily for death protection.

To determine if a contract is a MEC, a premium limit is set and is referred to as a seven pay limit or MEC limit. It is based on the annual premium that would pay up the policy after the payment of 7 level annual premiums. This is the max amount of premium that can be paid into the contract during the first 7 years from the date of issue to avoid MEC status, set by Internal Revenue status.

Question 12

MECS … Continued

Answer 12

Under what is known as the MEC test, the cumulative amount paid at any time in the first 7 years cannot exceed the cumulative MEC limit applicable in that policy year.

Example; a $50,000 flexible premium policy and the MEC limit is $1,000 each year for the first 7 years of the contract. $1,000 premium each year can be paid without triggering MEC status. If in the 4th policy year a $2,000 payment is made, the total cumulative premium payments ($5,000) would exceed the cumulative MEC premium limit of the $4,000, and the policy would be classified as a MEC. The insurer may refund any excess premiums within 60 days to avoid having a policy become a MEC.

• ONCE A MEC ALWAYS A MEC

Question 13

LAST MEC, I promise :)

Answer 13

• too much prem paid in first 7 years
• flexible premium universal life
• single premium whole life
• interest on cash values not taxed while in the policy
• withdrawals or loans are taxed
  - Interest out FIRST
  - 10% penalty on interest if withdrawn before age 59 1/2 unless insured diabled.
• Once a MEC always a MEC

Question 14

ANNUITIES!! PREMIUMS

Answer 14

Annuities Premiums are NOT tax deductible, unless the contract is held in a qualified retirement plan.

Question 15

ANNUITIES ACCUMULATIONS

Answer 15

Similar to life insurance, interest earnings credited to individual annuities are tax-deferred. They become taxable when they are paid out.

Question 16

ANNUITIES WITHDRAWALS

Answer 16

Distributions received from an annuity during the accumulation period receive the same tax treatment as a modified endowment contract.

Last in first out (LIFO) taxation- the entire taxable gain is received before any non taxable cost basis

If the contract owner is under the age of 59 1/2, a 10% penalty tax must be paid in addition to the regular tax due on any taxable amount received. The penalty does not apply if the owner is disabled.

Question 17

ANNUITY PAYMENTS

Answer 17

There are 2 phases to an annuity: accumulation “Pay in” and annuitization “Pay out”. If the owner withdraws money from an annuity in a lump sum, they face severe tax penalties on their savings. The most likely method is to receive periodic or monthly payments.

Question 18

EXCLUSION RATIO

Answer 18

Is used to determine the non taxable portion of each monthly payment. The formula is applied to each annuity payment to find the portion that is excludable from gross income. The remainder is taxable at ordinary rates.

The annuity owner paid $12,000 into the contract and it’s now worth $19,200. The exclusion ratio is $12,000/$19,200 or 62.5%. If the monthly payment received is $100, the portion that can be excluded from gross income is $62.50 or 62.5% of $100. The $37.50 balance of each $100 monthly payment is ordinary income.

Question 19

LUMP SUM

Answer 19

The beneficiary can take the proceeds all at once. The gain is taxable

Question 20

5 YEAR WITHDRAWAL PERIOD

Answer 20

The beneficiary must withdraw all proceeds within 5 years. These withdrawals are taxed the same as withdrawals during the owners life. That is, the gain is taxable and all the gain must be taken out before any non-taxable cost basis is withdrawn.

Question 21

ANNUITY PAYOUT

Answer 21

The beneficiary may take the proceeds under an annuity payout option. This option must be selected within one year from the date of the owners death. The payments are taxed as annuity payments– part taxable gain and part non-taxable cost basis, with the non-taxable amount determined using the exclusion ratio

Question 22

SPOUSAL OPTION

Answer 22

If the beneficiary is the owner’s spouse, ownership may be transferred to the spouse without tax consequences.

Question 23

SURVIVOR ANNUITANT

Answer 23

If payments are made under a joint and survivor annuity , they continue to be taxed as they were when made to both annuitants. If the entire cost basis has not yet been paid out, the same exclusion ratio percentage is used to determine the amount excludable from taxable income even if the payment to the survivor annuitant is reduced, such as under a joint and two thirds survivor annuity. Payments become fully taxable when the entire tax basis has been paid out.

Question 24

Beneficiary annuitant

Answer 24

If payments are made to a beneficiary under an annuity payout option that guarantees a certain payout, the entire payment becomes non-taxable until the entire cost basis has been paid out. At that point, any remaining guaranteed payments are fully taxable. If the entire cost basis was paid out to the annuitant, any guaranteed payments made to the beneficiary are taxable from the start.

Question 25

Beneficiary annuitant

Answer 25

If payments are made to a beneficiary under an annuity payout option that guarantees a certain payout, the entire payment becomes non-taxable until the entire cost basis has been paid out. At that point, any remaining guaranteed payments are fully taxable. If the entire cost basis was paid out to the annuitant, any guaranteed payments made to the beneficiary are taxable from the start.

Question 26

1035 EXCHANGES

Answer 26

Allows individuals to move cash values from one contract to another without having any gain taxed at that time.

Section 1035 applies to;
-Life insurance
-Annuities
The following movement of cash values qualifies under section 1035 with no taxable consequence:
-Life insurance to another life insurance policy
-Annuity to another annuity contract
-Life insurance to annuity contract
*The surrender of an annuity to move cash value to the cash values to a life insurance policy does not qualify as a 1035 exchange. The gain in the contract becomes taxable upon the surrender of the annuity**

Question 27

ESTATE TAX TREATMENT

Answer 27

Estate taxes are not owed if and estate’s value exceeds a certain values at the time of the individuals death. The taxes are a percentage of the estate’s value.
Life insurance death benefits are counted as value in a deceased insureds estate if:
- they are payable to the estate
-the deceased possessed any incidents of ownership in the policy at the time of death
the deceased assigned or transferred ownership of the policy to another person within 3 years of death

Question 28

ESTATE TAX TREATMENT WITH ANNUITIES

Answer 28

The estate tax treatment of annuities depends on whether the death occurs during the accumulation period or during the annuity period.

• If death occurs during the accumulation period, the entire value of the annuity– not just the gain, but also the cost basis– is included in the estate.
• If death occurs during the annuity period, the present value of any payments that will continue to a beneficiary or survivor annuitant is included in the estate.