Federal Tax Considerations For Life Insurance And Annuities PDF

Powered by ExamFX - Online Training & Assessment Federal Tax Considerations For Life Insurance And Annuities This section will help broaden your knowledge of life insurance and annuities by explaining the subject of taxation. You will learn the basic pri...

Powered by ExamFX - Online Training & Assessment Federal Tax Considerations For Life Insurance And Annuities This section will help broaden your knowledge of life insurance and annuities by explaining the subject of taxation. You will learn the basic principles of taxation of policy benefits, dividends, and loans, as well as options available for nontaxable exchanges. TERMS TO KNOW E a r n e d i n c o m e — salary, wages, or commissions; but not income from investments, unemployment benefits, and similar G ro s s i n c o m e — a person's income before taxes or other deductions F I FO ( F i r s t I n , F i r s t O u t ) — principle under which it is assumed that the funds paid into the policy first will be paid out first L I FO ( L a s t I n , F i r s t O u t ) — principle applied to asset management in life insurance products, under which it is assumed that the funds paid into the policy last will be paid out first N o n p rofit o r g a n i z a t i o n — an organization that uses its surplus to fulfill its purpose instead of distributing the surplus to its owners or members Po l i c y e n d o w m e n t — maturity date Po l i c y p ro c e e d s — in life insurance, the death benefit P re t a x c o n t r i b u t i o n — contribution made before federal and/or state taxes are deducted from earnings R o l l ove r — withdrawal of the money from one qualified plan and placing it into another plan S u r re n d e r — early termination of a policy by the policyowner Ta x d e d u c t i b l e — a reduction of taxable income, resulting in lower tax liability Ta x a b l e — subject to taxation, payable to state and federal government Ta x d e fe r re d — taxes on investments or gains (such as interest or dividends) are paid at a future date instead of in the period in which they are incurred tax Ve s t i n g — the right of a participant in a retirement plan to retain part or all of the benefits A. Qualified Plans Requirements An employer-sponsored qualified retirement plan is approved by the IRS, which then gives both the employer and employee benefits such as deductible contributions and tax-deferred growth. Qualified plans have the following characteristics:  Designed for the exclusive benefit of the employees and their beneficiaries; Are formally written and communicated to the employees; Use a benefit or contribution formula that does not discriminate in favor of the prohibited group — officers, stockholders, or highly paid employees; Are not geared exclusively to the prohibited group; Are permanent; Are approved by the IRS; and Have a vesting requirement. Know This! Qualified plans have tax advantages. In contrast, nonqualified plans are not subject to the requirements regarding participation, discrimination, and vesting as qualified plans. Nonqualified plans require no government approval and are used as a means for an employer to discriminate in favor of a valuable employee with regard to employee benefits. Nonqualified plans accept after-tax contributions. The table below highlights the differences between qualified and nonqualified retirement plans. QUALIFIED QUALIFIEDNONQUALIFIED NONQUALIFIED Contributions currently TAX Contributions NOT currently TAX DEDUCTIBLE DEDUCTIBLE Plan APPROVED by the IRSPlan DOES NOT NEED IRS APPROVAL Plan CANNOT DISCRIMINATEPlan CAN DISCRIMINATE Earnings grow TAX DEFERREDEarnings grow TAX DEFERRED ALL WITHDRAWALS are TAXEDEXCESS over cost basis is TAXED B. Types Of Qualified Plans 1. Individual Qualified Plans - IRA and Roth IRA The 2 most common qualified individual retirement plans are Traditional IRAs and Roth IRAs. Anybody with earned income can contribute to either plan. A Traditional Individual Retirement Account (IRA) allows individuals with earned income to make tax deductible contributions regardless of age. Previously, individuals were allowed to contribute to the account until the age of 70 ½; however, the SECURE Act of 2019 removed the prior age limit for all contributions starting in tax year 2020. Plan participants are allowed to contribute up to a specified dollar limit each year, or 100% of their salary if less than the maximum allowable amount. Individuals who are age 50 or older are entitled to make additional catch-up contributions. A married couple could contribute a specified amount that is double the individual amount, even if only one person had earned income. Each spouse is required to maintain a separate account not exceeding the individual limit. In traditional IRAs, the owner may withdraw the funds at any time. However, withdrawals prior to age 59 ½ are considered early withdrawals and are subject to a 10% additional tax. Starting at age 59 ½, the owner may withdraw assets without having to pay the 10% additional tax. However, the owner must start receiving distributions from the IRA at the age of 72 (the SECURE Act of 2019 raised the required minimum distribution age from 70 ½ to 72). Starting at age 72, the owner must receive at least a minimum annual amount, known as the required minimum distribution (RMD). The Roth IRA is a form of an individual retirement account funded with after- tax contributions. An individual can contribute 100% of earned income up to an IRS-specified maximum, as with traditional IRAs (the dollar amounts change every year). Roth IRA contributions can continue regardless of the account owner's age, and in contrast with a traditional IRA, distributions do not have to begin at age 72 (previously 70½). Roth IRAs grow tax free as long as the account is open for at least 5 years. Know This! Traditional IRAs and Roth IRAs are for individuals with earned income. Know This! Contributions to a traditional IRA are with pre-tax dollars (tax deductible; contributions to a Roth IRA are with after-tax dollars (NOT tax deductible). In addition to individual plans, different types of qualified plans are available and have been designed for use by small and large employers. 2. Simplified Employee Pensions (SEPs) A Simplified Employee Pension (SEP) is a type of qualified plan suited for the small employer or for the self-employed. In a SEP, an employee establishes and maintains an individual retirement account to which the employer contributes. Employer contributions are not included in the employee’s gross income. The primary difference between a SEP and an IRA is the much larger amount that can be contributed each year to a SEP (an IRS established annual dollar limit or 25% of the employee’s compensation, whichever is less). 3. SIMPLE Plans A SIMPLE (Savings Incentive Match Plan for Employees) plan is available to small businesses that employ no more than 100 employees who receive at least $5,000 in compensation from the employer during the previous year. To establish a SIMPLE plan, the employer must not have a qualified plan already in place. Employees who elect to participate may defer up to a specified amount each year, and the employer then makes a matching contribution, dollar for dollar, up to an amount equal to 3% of the employee's annual compensation. Taxation is deferred on both contributions and earnings until funds are withdrawn. 4. Profit Sharing and 401(k) Plans Profit-sharing plans are qualified plans where a portion of the company's profit is contributed to the plan and shared with employees. If the plan does not provide a definite formula for figuring the profits to be shared, employer contributions must be systematic and substantial substantial. A 401(k) qualified retirement plan allows employees to take a reduction in their current salaries by deferring amounts into a retirement plan. The company can also match the employee's contribution, whether it is dollar for dollar or on a percentage basis. Under a 401(k) plan, participants may choose to do one of the following: Receive taxable cash compensation; or Have the money contributed into the 401(k), in cash or deferred arrangement plans (CODA). Contributions into the plan are excluded from the individual employee's gross income up to a specified dollar amount. The ceiling amount is adjusted annually for inflation. The plan allows participants age 50 or over to make additional catch-up contributions (up to a limit) at the end of the calendar year. A 401(k) plan may be arranged as: 1. Pure salary reduction plan; 2. Bonus plan; or 3. Thrift plan. Under the bonus or thrift plan, the employer will contribute certain amount or percentage for each dollar contributed by the employee; however, employee contributions are not always required. Plans permit early withdrawal for specified hardship reasons such as death or disability. Loans are also permitted in certain instances up to 50% of the participant's vested accrued benefit or the annual IRS-established dollar amount. 5. 403(b) Tax-sheltered Annuities (TSAs) A 403(b) plan or a tax-sheltered annuity (TSA) is a qualified plan available to employees of certain nonprofit organizations under Section 501(c)(3) of the Internal Revenue Code, and to employees of public school systems. Contributions can be made by the employer or by the employee through salary reduction and are excluded from the employee’s current income. As with any other qualified plan, 403(b) limits employee contributions to a maximum amount that changes annually, adjusted for inflation. The same catch-up provisions also apply. Know This! 403(b) plans are for nonprofits and public-school systems. ELIGIBILITY ELIGIBILITYWHO WHO CONTRIBUTES HR-10 (Keogh) (Keogh)Self-employedEmployer matches employee's contributions SEP SEPSmall employer or self-employedEmployer only SIMPLE SIMPLESmall employers Employer matches employee's (no more than 100 contribution employees) 401(k) 401(k)Any employerEmployer matches employee's contribution 403(b) - TSA TSANonprofit organizations Employer and employee Know This! Contributions to qualified plans are limited to a maximum amount (established by the IRS). C. Taxation Of Qualified Plans If the general requirements for qualified plans are met, the following tax advantages apply: Employer contributions are tax deductible to the employer, and are not taxed as income to the employee; The earnings in the plan accumulate tax deferred; and Lump-sum distributions to employees are eligible for favorable tax treatment. 1. Traditional IRAs Contributions, Deductible Amounts, and Distributions The following taxation rules apply to contributions made to traditional IRA plans: Tax-deductible contributions for the year of the contribution (based on the person's income); Contributions must be made in "cash" in order to be tax deductible (the term cash includes any form of money, such as cash, check, or money order); Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA; and Tax-deferred earnings (the money that accumulates in the account) are not taxed until withdrawn. A distribution from an IRA is subject to income taxation in the year the withdrawal is made. In case of an early distribution (prior to age 59 ½), a 10% penalty will also apply. There are certain conditions, under which the 10% penalty for early withdrawals would not apply (penalty tax exceptions): Participant is age 59½; Participant is totally disabled;  The money is used to make the down payment on a home (not to exceed $10,000, and usually for first-time homebuyers); Withdrawals are for post-secondary education expenses; and Withdrawals are for catastrophic medical expenses, or upon death. Amounts Received by Beneficiary If the owner dies before distributions have begun, the entire interest must be distributed in full on or before December 31 of the calendar year of the 5th anniversary of the owner's death, unless the owner named a beneficiary. Spouses who are the sole designated beneficiary can do the following: Treat an IRA as their own; Base the required minimum distribution (RMD) on their own current age; Base the required minimum distribution on the decedent's age at death, reducing the distribution period by one each year; or Withdraw the entire account balance by the end of the 5th year following the account owner's death, if the account owner died before the required beginning date. If the account owner died before the required beginning date, the surviving spouse can wait until the owner would have turned 72 to begin receiving RMDs. Individual beneficiaries other than a spouse can do the following: Withdraw the entire account balance by the end of the 5th year following the account owner's death, if the account owner died before the required beginning date; or Calculate RMDs using the distribution period from the IRS Single Life Table based on the beneficiary's age at year-end following the year of the owner's death, reducing the distribution period by one for each subsequent year. 2. Roth IRAs The following taxation rules apply to Roth IRAs: Contributions are not tax deductible; and Excess contributions are subject to a 6% tax penalty. Know This! Traditional IRA distributions are taxable; Roth IRA distributions are NOT taxable. TRADITIONAL IRA IRAROTH ROTH IRA Contribute 100% of income up to an IRS-specified limit Excess contribution penalty is 6% Grows tax deferredGrows tax free (if account open for at least 5 years) Contributions are tax deductible Contributions are not tax deductible (Made with "pre-tax dollars") (Made with "after-tax dollars") 10% penalty for early nonqualified Qualified distribution cannot occur until distributions prior to age 59 ½ (some account is open for 5 years and owner is exceptions apply) 59½ Distributions are taxable Distributions are not taxable Payouts must begin by age of 72No required minimum age for payouts 3. Rollovers and Transfers Situations exist in which a person may choose to move the monies from one qualified retirement plan to another qualified retirement plan. However, benefits that are withdrawn from any qualified retirement plan are taxable the year in which they are received if the money is not moved properly. There are 2 ways to accomplish this: a rollover and a transfer from one account to another. A rollover is a tax-free distribution of cash from one retirement plan to another. Generally, IRA rollovers must be completed within 60 days from the time the money is taken out of the first plan. If the distribution from the first plan is paid directly to the participant, 20% of the distribution must be withheld by the payor. The 20% withholding of funds can be avoided if the distribution is made directly from the first plan to the trustee or administrator/custodian of the new IRA plan. This is known as direct rollover rollover. The term transfer (or direct transfer) refers to a tax-free transfer of funds from one retirement program to a traditional IRA or a transfer of interest in a traditional IRA from one trustee directly to another another. D. Taxation Of Personal Life Insurance Generally speaking, the following taxation rules apply to life insurance policies: Premiums are not tax deductible; and Death benefit: Tax free if taken as a lump-sum distribution to a named beneficiary; and Principal is tax free; interest is taxable if paid in installments (other than lump sum). 1. Amounts Available to Policyowner As you have already learned, permanent life insurance provides living benefits. There are several ways in which policyowners may receive those living benefits from the policy. Cash Value Increases Any cash value accumulations in the policy can be borrowed against by the policyowner, or may be paid to the policyowner upon surrender of the policy. Cash values grow tax deferred. Upon surrender or endowment, any cash value in excess of cost basis (premium payments) is taxable as ordinary income. Upon death, the face amount is paid, and there is no more cash value. Death benefits generally are paid to the beneficiary income tax free. Dividends Since dividends are a return of unused premiums, they are not considered income for tax purposes. When dividends are left with the insurer to accumulate interest, the interest earned on the dividend account is subject to taxation as ordinary income each year interest is earned, whether or not the interest is paid out to the policyowner. Policy Loans The policyowner may borrow against the policy's cash value. Money borrowed against the cash value is not income taxable; however, the insurance company charges interest on outstanding policy loans. Policy loans, with interest, can be repaid in any of the following ways: By the owner while the policy is in force; At policy surrender or maturity, subtracted from the cash value; or At the insured's death, subtracted from the death benefit. Know This! Policy loans from the cash value are NOT income taxable. Surrenders When a policyowner surrenders a policy for cash value, some of the cash value received may be taxable as income if the cash surrender value exceeds the amount of the premiums paid for the policy. When the owner withdraws cash value from a universal life policy (partial surrender), both the cash value and the death benefit are reduced by the surrender. Example: Consider the following scenario: Face amount: $300,000 Premiums paid: $70,000 Total cash value: $100,000 If the insured surrendered $30,000 of cash value, the full $30,000 would be income tax free. If the insured took out $100,000, the last $30,000 would be taxable because the $100,000 exceeds the premiums that were paid in by $30,000. 2. Amounts Received by Beneficiary General Rule and Exceptions Life insurance proceeds paid to a named beneficiary are generally free of federal income taxation if taken as a lump sum. An exception to this rule would apply if the benefit payment results from a transfer for value, meaning the life insurance policy is sold to another party prior to the insured's death. Know This! Lump-sum cash payment of life policy proceeds are tax free for the beneficiary. Settlement Options With settlement options options, when the beneficiary receives payments consisting of both principal and interest, the interest portion of the payments received is taxable as income. Example: If $100,000 of life insurance proceeds were used in a settlement option paying $13,000 per year for 10 years, $10,000 per year would be income tax free and $3,000 per year would be income taxable. Know This! In settlement options, the principal is tax free, but the interest is taxable. 3. Values Included in Insured's Estate The death benefit or face amount of a life insurance policy may be included in the insured's taxable estate at death and subject to the federal estate tax tax. There are essentially 3 situations that will result in life insurance being included in the insured's taxable estate. 1. Incidents of ownership — An incident of ownership is defined as any one of the rights of policy ownership, such as the right to cash value, the right to change the beneficiary, the right to obtain policy loans, or the right to assign the policy. If the insured/policyowner possessed any one of these incidents of ownership at the time of his or her death, the entire face amount of the policy will be included in the insured's taxable estate, even though the actual proceeds were paid out to the beneficiary. 2. Estate as beneficiary — If the insured's estate is the designated beneficiary at the time of the insured's death, the entire face amount of the policy will be included in his or her taxable estate. 3. Transfer of ownership — If the insured, as policyowner, assigns or transfers ownership of the policy or makes a gift of the policy within 3 years prior to his or her death, the entire face amount of the policy will be included in his or her taxable estate. PERMANENT LIFE FEATURES TAX TREATMENT PremiumsNot tax deductible Cash value exceeding premiums paidTaxable at surrender Policy loansNot income taxable Policy dividendsNot taxable Dividend interestTaxable in the year earned Lump-sum death benefitNot income taxable Know This! Taxes must be paid either upon contribution or upon distribution, NOT both (if taxed on one end, will not be taxed on the other). E. Modified Endowment Contracts (MECs) Following the elimination of many traditional tax shelters by the Tax Reform Act of 1984, single premium life insurance remained as one of the few financial products offering significant tax advantages. Consequently, many of these types of policies were purchased solely for purposes of setting aside large sums of money for the tax-deferred growth as well as tax-free cash flow available via policy loans and partial surrenders. 1. Seven-pay Test To curtail this activity, and to determine if an insurance policy is overfunded, the Internal Revenue Service (IRS) established what is known as the 7-pay Test Test. Any life insurance policy that fails a 7-pay test is classified as a Modified Endowment Contract (MEC) (MEC), and loses the standard tax benefits of a life insurance contract. In a MEC, the cumulative premiums paid during the first 7 years of the policy exceed the total amount of net level premiums that would be required to pay the policy up using guaranteed mortality costs and interest. Once a policy fails the 7-pay test and becomes a MEC, it remains a MEC. Know This! A MEC is an overfunded life insurance policy = failed the 7- pay test. Know This! Once a MEC, always a MEC! 2. MEC vs. Life Insurance All life insurance policies are subject to the 7-pay test, and any time there is a material change to a policy (such as an increase in the death benefit), a new 7- pay test is required. Whether from a life insurance policy or a MEC, the death benefit received by the beneficiary is tax free. 3. Distributions The following are taxation rules that apply to MEC's cash value: Tax-deferred accumulations; Any distributions are taxable, including withdrawals and policy loans; Distributions are taxed on LIFO basis (Last In, First Out) — known as "interest- first" rule; and Distributions before age 59 ½ are subject to a 10% penalty. TAX CONSIDERATIONS FOR LIFE INSURANCE AND ANNUITIES Premiums Not deductible (personal expense) Death Benefit BenefitNot Not income taxable (except for interest) Cash Value Increases IncreasesNot Not taxable (as long as policy in force) Cash Value Gains GainsTaxed Taxed at surrender Dividends DividendsNot Not taxable (return of unused premium; however, interest is taxable) Accumulations AccumulationsInterest Interest taxable Policy Loans LoansNot Not income taxable Surrenders SurrendersSurrender Surrender value - past premium = amount taxable Partial Surrenders SurrendersFirst First In, First Out (FIFO)* Settlement Options - death benefit spread evenly over income period (averaged). Interest payments in excess of death benefit portion are taxable. Estate Tax - If the insured owns the policy, it will be included for estate tax purposes. If the policy is given away (possibly to a trust) and the insured dies within 3 years of the gift, the death benefit will be included in the estate. *FIFO applies to Life insurance only. Annuities follow a LIFO format. F. Chapter Recap In this chapter you learned about different types of individual and group qualified plans and their characteristics. This chapter also explained the basic taxation principles for life insurance, including taxable, tax-deductible and tax- free features and transactions. Let’s recap the major points: QUALIFIED PLANS General Approved by the IRS Requirements Tax benefits for employers and employees Must be permanent and have a vesting requirement Cannot discriminate in favor of the prohibited group Individual Qualified Traditional IRA requirements and features: Plans Earned income Contributions: - Pretax - No limiting age - Dollar limit - up to a maximum allowed amount - Married couples - double the amount for singles Withdrawals must begin at age 59 ½ and not later than 72 Roth IRA: Earned income Contributions: - After tax - No limiting age - Dollar limit - up to a maximum allowed amount Withdrawals do not have to begin at age 72 Employer-sponsored General characteristics: Qualified Plans  Contributions up to an IRS-specified amounts Both employer and employee can contribute Types of plans: SEP - small employer/self-employed; employer funds an employee's IRA SIMPLE - small employer (no more than 100 employees); set up as IRA or as 401(k) 401(k) - any employer; cash or deferred arrangements; profit sharing 403(b) - tax-sheltered annuity (TSA) - nonprofit organizations TAXATION Life Premiums - not tax deductible Insurance Cash value - taxable only if the amount exceeds premiums (taxed on gain) Policy loans - not taxable, interest not tax deductible Dividends - not taxable as return of premium; any interest is taxable Accelerated benefits - tax free Death benefit - not taxable if lump-sum; any interest is taxable Surrenders - taxable if the cash surrender value exceeds the amount of the premium paid IRAs Contributions - pretax, tax deductible (must be made in cash) Earnings - tax deferred Distributions - taxable; 10% penalty for early withdrawals Roth IRAs Contributions - after tax, NOT tax deductible Distributions - not taxable OTHER RELATED CONCEPTS Rollovers and Tax-free transactions Transfers Distribution of money from one qualified retirement plan to another Must be completed within 60 days If from plan to the participant, 20% of distribution is withheld If from plan to trustee, no withholdings (direct rollover) Modified Endowment Contract Overfunded life insurance policy (7- (MEC) pay test) Accumulation - tax deferred Distributions - taxable Last In, First Out Distributions before age 59 ½ - 10% penalty