Taxation of Life Insurance and Annuities

Podcast

Play an AI-generated podcast conversation about this lesson

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?

An additional contribution for participants age 50 or older. Signup and view all the answers

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

They are specific to employees of nonprofit organizations and public schools. Signup and view all the answers

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

There are maximum contribution limits adjusted annually. Signup and view all the answers

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

For specified hardship reasons such as disability or death. Signup and view all the answers

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

To make systematic and substantial contributions. Signup and view all the answers

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

60 days 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?

20% Signup and view all the answers

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

Not tax deductible Signup and view all the answers

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

It is taxable as ordinary income if it exceeds cost basis Signup and view all the answers

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

Not considered income Signup and view all the answers

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

It avoids 20% withholding. 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?

Taxed as ordinary income each year Signup and view all the answers

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

It is paid out income tax-free to the beneficiary. 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)?

Base RMDs on their own age or the decedent's age. Signup and view all the answers

Which of the following statements about Roth IRAs is TRUE?

Distributions are not taxable if certain conditions are met. Signup and view all the answers

What is true regarding the taxation of traditional IRA distributions?

Distributions are taxable in the year received. Signup and view all the answers

What is a requirement for contributing to a Roth IRA?

Contributions are made with after-tax dollars. Signup and view all the answers

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

They must calculate RMDs from the Single Life Table based on their age. Signup and view all the answers

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

The account owner must have died before the required beginning date. Signup and view all the answers

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

The account must be open for at least 5 years. 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?

The withdrawn amounts are taxed in the year they are received. Signup and view all the answers

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

It remains a MEC indefinitely. Signup and view all the answers

How are distributions from a MEC taxed?

On a last-in, first-out (LIFO) basis. Signup and view all the answers

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

They are not deductible. Signup and view all the answers

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

The taxable amount is calculated by subtracting past premiums from the surrender value. Signup and view all the answers

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

10% penalty on the distribution amount. Signup and view all the answers

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

Dividends are considered a return of unused premium and are not taxable. Signup and view all the answers

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

If the insured dies within three years after gifting the policy. Signup and view all the answers

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

Cash value increases are not taxable as long as the policy is in force. Signup and view all the answers

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

It is subtracted from the death benefit. Signup and view all the answers

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

Only the amount over the premiums is taxable. Signup and view all the answers

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

When taken as a lump sum. Signup and view all the answers

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

Only the interest portion. Signup and view all the answers

Which of the following statements is true regarding policy loans?

Policy loans reduce the cash value of the policy. Signup and view all the answers

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

It reduces both cash value and death benefit. Signup and view all the answers

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

If the policy is sold before the insured's death. Signup and view all the answers

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

A portion of the cash value may be taxable as income. Signup and view all the answers

What is a key requirement for qualified plans?

Must have a vesting requirement Signup and view all the answers

Which statement accurately describes a Roth IRA?

Contributions are made with after-tax income Signup and view all the answers

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

It is specifically designed for self-employed individuals Signup and view all the answers

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

Loans are not taxable, interest is not tax deductible Signup and view all the answers

What defines a Modified Endowment Contract (MEC)?

An overfunded life insurance policy that fails the 7-pay test Signup and view all the answers

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

The funds are taxed immediately Signup and view all the answers

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

When the cash value exceeds the total premiums paid Signup and view all the answers

How are contributions made to a traditional IRA characterized?

Pretax contributions that are tax deductible Signup and view all the answers

Which statement is true regarding distributions from Roth IRAs?

Distributions are not taxable Signup and view all the answers

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

They involve easy setup with no more than 100 employees Signup and view all the answers

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.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Explore the federal tax implications of life insurance and annuities. This quiz covers key terms and concepts such as earned income, gross income, and exchange options, providing a detailed understanding of taxation on benefits and loans.