Taxation of Life Insurance and Annuities
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Questions and Answers

What is a feature of a 401(k) plan regarding employee contributions?

  • Employee contributions are always required.
  • Participants can only receive taxable cash compensation.
  • Contributions are excluded from gross income up to a specified limit. (correct)
  • Employer contributions cannot exceed employee contributions.

What is the purpose of a profit-sharing plan?

  • To enforce mandatory employee contributions.
  • To guarantee employees a fixed retirement income.
  • To provide employees with immediate cash compensation.
  • To systematically share a portion of the company's profits with employees. (correct)

Which option is NOT a type of arrangement under a 401(k) plan?

  • Thrift plan
  • Bonus plan
  • Investment plan (correct)
  • Pure salary reduction plan

What is a catch-up contribution in a 401(k) plan?

<p>An additional contribution for participants age 50 or older. (D)</p> Signup and view all the answers

Which of the following is a key characteristic of 403(b) plans?

<p>They are specific to employees of nonprofit organizations and public schools. (A)</p> Signup and view all the answers

What limitation applies to contributions made to a 403(b) plan?

<p>There are maximum contribution limits adjusted annually. (C)</p> Signup and view all the answers

Under what circumstances can a participant withdraw from their 401(k) plan early?

<p>For specified hardship reasons such as disability or death. (A)</p> Signup and view all the answers

What is one of the employer's responsibilities in a profit-sharing plan?

<p>To make systematic and substantial contributions. (A)</p> Signup and view all the answers

What is the primary time constraint for completing an IRA rollover?

<p>60 days (A)</p> Signup and view all the answers

What percentage of a distribution must be withheld if the payment is made directly to the participant during an IRA rollover?

<p>20% (A)</p> Signup and view all the answers

In terms of taxation, how are premiums paid for life insurance policies classified?

<p>Not tax deductible (A)</p> Signup and view all the answers

What happens to the cash value in a permanent life insurance policy upon surrender?

<p>It is taxable as ordinary income if it exceeds cost basis (C)</p> Signup and view all the answers

What is the status of dividends paid from a life insurance policy for tax purposes?

<p>Not considered income (B)</p> Signup and view all the answers

Which of the following statements about a direct rollover is true?

<p>It avoids 20% withholding. (B)</p> Signup and view all the answers

Which of the following accurately describes the treatment of interest earned on dividends left with an insurer to accumulate interest?

<p>Taxed as ordinary income each year (A)</p> Signup and view all the answers

What occurs to the face amount of a permanent life insurance policy when the insured passes away?

<p>It is paid out income tax-free to the beneficiary. (D)</p> Signup and view all the answers

What can a surviving spouse who is the designated beneficiary of an IRA do regarding required minimum distributions (RMDs)?

<p>Base RMDs on their own age or the decedent's age. (C)</p> Signup and view all the answers

Which of the following statements about Roth IRAs is TRUE?

<p>Distributions are not taxable if certain conditions are met. (C)</p> Signup and view all the answers

What is true regarding the taxation of traditional IRA distributions?

<p>Distributions are taxable in the year received. (C)</p> Signup and view all the answers

What is a requirement for contributing to a Roth IRA?

<p>Contributions are made with after-tax dollars. (A)</p> Signup and view all the answers

Which statement accurately describes the withdrawal rules for individual beneficiaries other than spouses?

<p>They must calculate RMDs from the Single Life Table based on their age. (D)</p> Signup and view all the answers

Which condition must be met for the surviving spouse to withdraw the entire account balance of an IRA?

<p>The account owner must have died before the required beginning date. (D)</p> Signup and view all the answers

What is required for a qualified distribution from a Roth IRA?

<p>The account must be open for at least 5 years. (A)</p> Signup and view all the answers

When moving funds from one qualified retirement plan to another, what is a consequence of not following the proper procedures?

<p>The withdrawn amounts are taxed in the year they are received. (D)</p> Signup and view all the answers

What happens to a policy once it fails the 7-pay test and becomes a MEC?

<p>It remains a MEC indefinitely. (C)</p> Signup and view all the answers

How are distributions from a MEC taxed?

<p>On a last-in, first-out (LIFO) basis. (C)</p> Signup and view all the answers

What is the tax treatment of premiums paid for a life insurance policy?

<p>They are not deductible. (D)</p> Signup and view all the answers

What taxable event occurs when an insured person surrenders a life insurance policy?

<p>The taxable amount is calculated by subtracting past premiums from the surrender value. (D)</p> Signup and view all the answers

What is the penalty for distributions from a MEC before age 59½?

<p>10% penalty on the distribution amount. (B)</p> Signup and view all the answers

Which of the following statements about dividends from a life insurance policy is accurate?

<p>Dividends are considered a return of unused premium and are not taxable. (C)</p> Signup and view all the answers

In which situation is the death benefit included in the insured's estate for tax purposes?

<p>If the insured dies within three years after gifting the policy. (D)</p> Signup and view all the answers

Which statement correctly describes cash value increases in a life insurance policy?

<p>Cash value increases are not taxable as long as the policy is in force. (C)</p> Signup and view all the answers

What happens to a policy loan if the insured passes away?

<p>It is subtracted from the death benefit. (B)</p> Signup and view all the answers

What is the tax implications if the cash surrender value exceeds the premiums paid?

<p>Only the amount over the premiums is taxable. (C)</p> Signup and view all the answers

When are life insurance proceeds generally considered free of federal income taxation?

<p>When taken as a lump sum. (C)</p> Signup and view all the answers

What portion of the payment is taxable when using a settlement option?

<p>Only the interest portion. (A)</p> Signup and view all the answers

Which of the following statements is true regarding policy loans?

<p>Policy loans reduce the cash value of the policy. (A)</p> Signup and view all the answers

What effect does a partial surrender of cash value have on the death benefit?

<p>It reduces both cash value and death benefit. (C)</p> Signup and view all the answers

In which situation would the death benefit be included in the insured's taxable estate?

<p>If the policy is sold before the insured's death. (C)</p> Signup and view all the answers

What is a potential consequence of surrendering a policy for cash value?

<p>A portion of the cash value may be taxable as income. (D)</p> Signup and view all the answers

What is a key requirement for qualified plans?

<p>Must have a vesting requirement (C)</p> Signup and view all the answers

Which statement accurately describes a Roth IRA?

<p>Contributions are made with after-tax income (C)</p> Signup and view all the answers

What distinguishes a SEP plan from other employer-sponsored plans?

<p>It is specifically designed for self-employed individuals (B)</p> Signup and view all the answers

What is the tax implication of policy loans obtained from life insurance?

<p>Loans are not taxable, interest is not tax deductible (A)</p> Signup and view all the answers

What defines a Modified Endowment Contract (MEC)?

<p>An overfunded life insurance policy that fails the 7-pay test (B)</p> Signup and view all the answers

What happens when a rollover is not completed within the specified period?

<p>The funds are taxed immediately (C)</p> Signup and view all the answers

In what situation might cash value from a life insurance policy be taxable?

<p>When the cash value exceeds the total premiums paid (A)</p> Signup and view all the answers

How are contributions made to a traditional IRA characterized?

<p>Pretax contributions that are tax deductible (A)</p> Signup and view all the answers

Which statement is true regarding distributions from Roth IRAs?

<p>Distributions are not taxable (A)</p> Signup and view all the answers

What is a unique feature of SIMPLE plans compared to other employer-sponsored plans?

<p>They involve easy setup with no more than 100 employees (A)</p> Signup and view all the answers

Flashcards

Profit-sharing plan

A qualified plan where a portion of company profits is shared with employees.

401(k) plan

A qualified retirement plan allowing salary reduction and contributions.

401(k) contribution limits

Specific dollar amounts for employee contributions, adjusted annually for inflation.

401(k) catch-up contributions

Additional contributions for employees aged 50 or over, up to a limit.

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403(b) plan

A qualified plan for nonprofit employees and public school systems.

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403(b) contributions

Contributions made by employees or the employer, excluded from current income.

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Tax-sheltered annuity (TSA)

Another name for a 403(b) plan.

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Taxation deferral

Taxes on contributions and earnings are delayed until withdrawal.

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Spouse IRA beneficiary options

Spouses can treat the IRA as their own, use their own age for required minimum distributions (RMDs), use the deceased spouse's age with a reduced distribution period every year, or withdraw the full balance in 5 years if the owner died before the RMD start date.

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Non-spouse IRA beneficiary RMDs

Non-spouses calculate RMDs based on their own age using the IRS Single Life Table, reducing the distribution period annually.

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Roth IRA contributions

Roth IRA contributions are not tax deductible.

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Roth IRA excess contributions penalty

Excess Roth IRA contributions are penalized at 6%.

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Traditional IRA distributions

Traditional IRA distributions are taxable.

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Roth IRA distributions

Roth IRA distributions are not taxable if the account is open for 5 years and the owner is 59 1/2 or older.

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Traditional IRA required minimum distributions (RMDs)

Payouts must begin by age 72 for traditional IRAs.

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Improper rollover/transfer consequences

Withdrawing money from a qualified retirement plan and not transferring it properly to another plan results in immediate taxes on the withdrawn amount.

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IRA Rollover

A tax-free transfer of cash from one retirement account to another.

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Direct Rollover

A rollover where funds are transferred directly from the first plan to the new plan's trustee or custodian, avoiding 20% withholding.

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Transfer (or Direct Transfer)

A tax-free transfer of funds between retirement programs, or from one IRA trustee to another.

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Life Insurance Premiums

Payments made to maintain a life insurance policy.

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Life Insurance Death Benefit (lump-sum)

The payout upon the death of the policyholder, tax-free when paid directly to the beneficiary.

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Life Insurance Cash Value (surrender)

Tax upon surrender amount exceeding premium payments, tax-deferred growth.

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Life Insurance Dividends

Return of unused premiums, not considered income.

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Life Insurance Policy Loan

Borrowing against the policy's cash value.

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Policy Loan

Money borrowed against the cash value of a life insurance policy. It's not taxable income but incurs interest.

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Policy Loan Repayment

Policy loans can be repaid by the policyholder while the policy is active, deducted from the cash value at surrender or maturity, or subtracted from the death benefit.

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Cash Surrender Tax

When a policy is surrendered, a portion of the cash value may be taxable if it exceeds the premiums paid.

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Universal Life Surrender

Partial surrender of a universal life policy reduces both the cash value and the death benefit.

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Life Insurance Death Benefit

The lump-sum payment made to the beneficiary upon the insured's death, generally tax-free.

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Transfer for Value Exception

If a life insurance policy is sold before the insured's death, the death benefit may become taxable.

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Settlement Option Interest

When a beneficiary receives payments over time under a settlement option, the interest portion is taxable income.

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Estate Tax & Life Insurance

The death benefit may be included in the insured's taxable estate and subject to the federal estate tax.

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MEC

A Modified Endowment Contract (MEC) is a life insurance policy that fails the 7-pay test, resulting in unfavorable tax treatment. Once a policy becomes a MEC, it remains a MEC regardless of future changes.

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7-pay test

A test that determines if a life insurance policy has been overfunded. If a policy fails the 7-pay test, it becomes a MEC (Modified Endowment Contract) with less favorable tax benefits.

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Taxability of MEC Distributions

Withdrawals and loan proceeds from a MEC are taxed as ordinary income. They are also subject to a 10% penalty if taken before age 59 1/2.

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LIFO Taxation

MEC distributions are taxed on a Last In, First Out (LIFO) basis, meaning the most recent contributions are taxed first. This is sometimes referred to as the 'interest-first' rule.

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Cash Value Increases

Increases in the cash value of a life insurance policy are not taxed as long as the policy remains in force. This means the buildup of cash value is tax-deferred.

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Cash Value Gains upon Surrender

When a life insurance policy is surrendered, any gains are taxed as ordinary income. The taxable amount is calculated by subtracting the total premiums paid from the surrender value received.

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Qualified Plans

Retirement plans approved by the IRS that offer tax benefits for both employers and employees. These plans have specific requirements, including vesting, and cannot discriminate in favor of certain groups.

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Individual Qualified Plans

Retirement plans available to individuals, such as Traditional and Roth IRAs. These plans have specific contribution and withdrawal rules.

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Traditional IRA

A retirement plan where contributions are made pre-tax, and earnings grow tax-deferred. Distributions are taxable.

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Roth IRA

A retirement plan where contributions are made after-tax, and both earnings and distributions are tax-free.

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Employer-Sponsored Qualified Plans

Retirement plans offered by employers, allowing both employees and employers to contribute. They offer a variety of options, including SEP, SIMPLE, 401(k), and 403(b) plans.

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SEP (Simplified Employee Pension)

A retirement plan primarily for small businesses and self-employed individuals. Employers fund the employees' IRAs.

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SIMPLE IRA

A retirement plan suitable for small employers with less than 100 employees. It can be set up as a traditional IRA or as a 401(k) plan.

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403(b) Plan (TSA)

A retirement plan designed for employees of non-profit organizations and public schools. It's also known as a tax-sheltered annuity.

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Rollovers and Transfers

Tax-free transactions involving the movement of money between qualified retirement plans. They must be completed within a specific timeframe, and certain tax implications may apply.

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Study Notes

Federal Tax Considerations for Life Insurance and Annuities

  • This section details taxation of life insurance and annuity benefits, dividends, and loans, along with options for nontaxable exchanges.

Terms to Know

  • Earned income: Salary, wages, or commissions; excluding investment income, unemployment benefits, etc.
  • Gross income: A person's income before taxes or deductions.
  • FIFO (First In, First Out): Funds paid into a policy are assumed to be paid out first.
  • LIFO (Last In, First Out): Funds paid into a policy are assumed to be paid out last.
  • Nonprofit organization: An organization using its surplus to fulfill its purpose, not distributing it to owners.
  • Policy endowment: Maturity date of a life insurance policy.
  • Policy proceeds: The death benefit in life insurance.
  • Pretax contribution: A contribution made before federal and/or state taxes are deducted.
  • Rollover: Transfer of funds from one qualified plan to another.
  • Surrender: Early termination of a policy.
  • Tax deductible: A reduction in taxable income, leading to lower tax liability.
  • Taxable: Subject to taxation, paid to the government.
  • Tax deferred: Taxes on investments are paid at a future date instead of when incurred.
  • Vesting: The right of a plan participant to keep a portion or all of the benefits.

A. Qualified Plans Requirements

  • An employer-sponsored qualified retirement plan is IRS-approved, offering tax-deductible contributions and tax-deferred growth.
  • Qualified plans benefit both employees and employers.
  • Key characteristics include exclusive benefit for employees and beneficiaries, formal written communication to employees, contribution and benefit formulas not discriminating in favor of officers, stockholders, or highly paid employees, and a permanent structure.

B. Types of Qualified Plans

  • Individual Qualified Plans (IRA and Roth IRA): Traditional IRAs allow tax-deductible contributions regardless of age (up to a yearly dollar limit or 100% of salary, whichever is less; with a higher limit for those aged 50 or older). Roth IRAs are funded with after-tax contributions and grow tax-free, as long as the account is open for at least 5 years.
  • Individual Roth IRA contributions allow individuals with earned income to make tax-deductible contributions regardless of age.

C. Taxation of Qualified Plans

  • Employer contributions are tax-deductible to the employer and not taxed as income to the employee.
  • Plan earnings accumulate tax deferred.
  • Lump-sum distributions to employees are eligible for favorable tax treatment.

1. Traditional IRAs

  • Tax-deductible contributions are made based on the contributor's income up to an IRS-specified limit.
  • Contributions are often made in cash.
  • Excess contributions are taxed at 6% per year until withdrawn.
  • Tax-deferred earnings are not taxed until withdrawn.
  • Distributions from an IRA are subject to income taxation when withdrawn, with a 10% penalty for early withdrawals (prior to age 59 1/2), although there are exceptions.

2. Roth IRAs

  • Contributions are not tax-deductible.
  • Excess contributions are subject to a 6% tax penalty.
  • Traditional IRA distributions are taxable; Roth IRA distributions are not.

D. Taxation of Personal Life Insurance

  • Premiums are not tax-deductible.
  • Death benefits are tax-free if paid as a lump sum to a named beneficiary.
  • Interest is taxable if paid in installments (other than lump sum).

E. Modified Endowment Contracts (MECs)

  • MECs (Modified Endowment Contracts) are over-funded life insurance policies that fail a 7-pay test.
  • MECs no longer receive normal tax benefits.

F. Chapter Recap

  • This chapter details various qualified plans and life insurance taxation.
  • Key considerations for taxation include contributions, distributions, and tax-free aspects of life insurance and qualified plans.

G. Qualified Plans (General Requirements)

  • IRS approval is needed.
  • Must be permanent, with a vesting requirement.
  • Cannot discriminate in favor of officers, stockholders, or highly paid employees.

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Federal Tax Considerations For Life Insurance And Annuities PDF

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