Unit 10: Taxation Of Life Insurance Annuities

Question 1

How are premiums paid for individual life insurance taxed?

Answer 1

Not tax-deductible

Question 2

How is interest earned on life insurance cash values taxed?

Answer 2

•not taxable while remains inside the policy
•policyowner is taxed if gain is withdrawn

Question 3

How are full surrenders of life insurance taxed?

Answer 3

•when a life insurance policy is surrendered, any gain in the cash value is taxable
•gain=[cash value]-[policy’s cost basis, i.e., the sum of all premiums paid]
•so cash value accumulations are tax-deferred, but not tax-free

Question 4

How are withdrawals (partial surrenders) of life insurance taxed?

Answer 4

•taxable to the extent of any gain
•taxed on a first-in-first-out (FIFO) basis
—>money withdrawn is considered to come from the premiums paid (cost basis) FIRST & cost basis withdrawals are NOT taxable
•when a withdrawal exceeds the cost basis, the excess is taxable

Question 5

How are policy loans on life insurance taxed?

Answer 5

•NOT taxable to the policyowner & NEVER become taxable every when the insured dies
•if a policy is surrendered or lapses, any portion of the loan amount that exceeds the policy’s cost basis is a taxable gain
•interest paid on policy loans is NOT tax-deductible

Question 6

How are dividends in life insurance taxed?

Answer 6

•NOT taxable
•if left to accumulate interest, the interest is taxable

Question 7

How are death benefits in life insurance taxed?

Answer 7

•NOT taxed if paid in a lump sum to a named beneficiary (individual or business)
•interest is taxable
•if paid over time, the original death benefit is NOT taxed & any interest earned on the proceeds are taxable as ordinary income when paid to the beneficiary

Question 8

How are accelerated death benefits in life insurance taxed?

Answer 8

NOT taxed

Question 9

How are business life insurance policies taxed?

Answer 9

•premiums are NOT tax deductible except for executive bonus
•death benefits are NOT taxable
•premiums for executive bonus policies are taxable income to the employee

Question 10

How is group life insurance taxed?

Answer 10

•premiums paid by the employer are tax deductible
•premiums paid by the employee are NOT tax deductible
•death benefits to a named beneficiary are NOT taxable
•premiums paid by employer for insurance above $50k is taxable income to the employee

Question 11

Modified endowment contracts (MECs)

Answer 11

•too much premium paid in first 7 years of the policy
—>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 59.5 unless insured is disabled
•once a MEC, always a MEC

Question 12

How are annuity premiums taxed?

Answer 12

NOT tax-deductible (unless the contract is held in a qualified retirement plan)

Question 13

How are accumulations in individual annuities taxed?

Answer 13

•interest earnings credited to individual annuities are tax-deferred
—>become taxable when they’re paid out
•earnings on annuities owned by corporations are taxable when they are credited

Question 14

How are withdrawals from an annuity taxed?

Answer 14

•last-in-first-out (LIFO)-the entire taxable gain is received before any non-taxable cost basis
•interest out first, income tax on interest
•10% penalty on interest if younger than 59.5-penalty is waived for disability

Question 15

How are annuity payments after annuitization taxed?

Answer 15

•taxed according to the exclusion ratio
•(premiums paid in)/(total of expected payments over annuitant’s life expectancy)=% of payment NOT taxed
•if annuitant lives beyond life expectancy, 100% of payment becomes taxable

Question 16

What are the beneficiary’s options for distributions from an annuity at death?

Answer 16

•lump sum-all of the gain is taxable
•5-year withdrawal period-takes all proceeds within 5 years; gain is taxable & all of the gain must be taken out before any non-taxable cost basis
•annuity payments-taxed according to the exclusion ratio
•spousal option-if the beneficiary is the owner’s spouse, ownership may be transferred to the spouse without any tax consequences

Question 17

What are section 1035 exchanges?

Answer 17

•section 1035 of the tax code allows individuals to move cash values from one contract to another without having any gain taxed at that time
•old & new life insurance policies must have the same policyowner & same insured
•old & new annuity contracts must have the same contract owner & same annuitant

Section 1035 exchange applies to:
1. Life insurance
2. Annuities

Not taxable:
•life to life
•annuity to annuity
•life to annuity

**annuity to life does NOT qualify

Question 18

For tax purposes, what are considered to be a return of a portion of the premium paid for the policy?

Answer 18

Dividends

Question 19

How are estates taxed (regarding life insurance)?

Answer 19

•estate taxes owed if an estate’s value exceeds a certain value at the time of the individual’s death
•taxes are a % of the estate’s value

•taxes due on transfer of wealth
•life insurance death benefits are included as insured’s gross estate if:
-payable to the insured’s estate
-insured owns the policy at time of death
-insured transferred ownership within 3 years of death

Question 20

How are estates taxed (regarding annuities)?

Answer 20

•if death occurs during the accumulation period, the entire value of the annuity (including both the gains & the cost basis) is included in the estate
•if death occurs during the annuitization period, the present value of any payments that will continue to a beneficiary or survivor annuitant is included in the estate

Question 21

What do the penalties assessed against MECs primarily affect?

Answer 21

Money taken out of the policy

Question 22

What is the general rule for federal tax purposes for life insurance premiums & annuity premiums?

Answer 22

Neither are tax-deductible

Question 23

For accelerated death benefits to receive the same tax treatment as regular death benefits, the insured must be certified to have an illness or physical condition that can reasonably be expected to result in death within __________.

Answer 23

24 months