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36 Cards in this Set
Premiums - Taxation
1. For individuals, premiums are considered a personal expense and are not deductible.
2. When an employer pays the premium on an employee’s contract, the premium is taxdeductible
as a business expense to the employer unless named as the beneficiary.
3. Employer paid premiums in connection with group life insurance shall not constitute
taxable income to the employee unless the death benefit exceeds $50,000. All premiums
for amounts above $50,000 are reported as taxable income.
Cash Values - Taxation
1. A cash value policy will experience increases in the cash value annually. These
increases are not taxable at the time they are credited to the policy.
2. Upon the partial withdrawal of cash or the surrender of a policy, the owner is taxed on
the contract equity. This is the Cost Recovery Rule. The cash value minus the sum
of premiums paid equals equity.
Policy Loans - Taxation
1. The interest paid on a personal loan from a cash value policy is not tax-deductible.
2. The interest paid on a life insurance loan is considered personal, and has not been
deductible since 1990.
Dividends - Taxation
1. The dividends themselves are not taxable since dividends are considered a return of
2. In general, interest earned on dividends is taxable as ordinary income in the year earned.
Amounts received by the Beneficiary (Claims) - Taxation
1. As a general rule, the principal is not considered taxable income, but any earned interest
2. Lump sum death benefits are exempt of any income taxes.
3. When installment payments via settlement options include principal and interest, the
interest is taxed as ordinary income in the year received.
Accelerated Death Benefits - Taxation
Generally, the payment of an accelerated death benefit is not reported as taxable income to a
recipient if the benefit payment is “qualified.” To be a qualified benefit the benefit must meet
the following conditions:
1. A physician must give a prognosis of 24 months or less, life expectancy, for the named
2. The amount of the benefit must at least be equal to the present value of the reduced
death benefit remaining after payment of the accelerated benefit.
3. The insurer provides a monthly report for the insured showing the amount paid and the
amount of benefit remaining in the life insurance policy.
The Accelerated Death Benefit is normally referred to as a rider. (Some state codes refer
to this benefit as a provision while others call it an option.) It may be used for Terminal
Illness, Chronic Disease, Nursing Home, and Long-Term Care benefits. It is not a source
of Disability Income benefits. It is an advance of the death benefit while the insured is still
alive and is also known as a Living Benefit.
Values Included in Insured’s Estate - Taxation
Life insurance proceeds are included as part of the insured’s taxable estate when:
1. The insured has any incidence of ownership at the time of death.
2. The proceeds are payable to the insured’s estate.
3. The transferred ownership or gifting occurred within three years of death.
Charitable Gifts of Life Insurance - Taxation
1. The donor may remain anonymous if so desired.
2. The receiving charity’s future value of the life insurance policy is the death benefit.
3. The entire amount is guaranteed even if the insured dies after only one premium payment.
4. Very little documentation is necessary for the IRS.
1. May be an insurable interest concern in some states.
2. Death benefit might (in some cases) become part of a decedent’s estate.
Modified Endowment Contracts (MECs)
The Technical and Miscellaneous Revenue Act of 1988
After June 20, 1988, all life insurance contracts issued which do not pass the 7-Pay Test are
identified as Modified Endowment Contracts (MECs) and, therefore, lose many of their tax
advantages. Policies dated prior to June 20 are grandfathered and are not required to meet the 7-Pay
Test. Once a contract is determined to be a MEC, it remains a MEC for the life of the contract.
1. The 7-Pay Test compares the premiums paid for the policy during the first seven years
with seven annual net level premiums for a 7-Pay Policy; Single premium life is always a
MEC. The IRS views the increase in the face amount as a material change; this requires
a new 7-Pay Test. A policy issued prior to June 20, 1988 must pass the 7-Pay Test if
the face amount is increased by a material change. Increases by a paid up additions
dividend option or a cost of living rider are not considered as material changes.
2. If a contract is deemed to be a MEC, then any funds that are distributed are subject to a
“last-in, first-out” tax treatment, rather than the normal “first-in, first-out” tax treatment.
3. Funds distributed are also subject to a 10% penalty on any taxable gains withdrawn
before age 59 ½.
This is considered a premature distribution.
4. Taxable distributions include partial withdrawals, cash value surrenders and policy loans
(including automatic premium loans).
Excess distributions exempt from the 10% penalty
1. Distributions made on or after the taxpayer reaches age 59 ½.
2. Distributions attributable to the death or total disability of the recipient.
3. Part of a series of equal periodic payments (at least annually) made for the life of
the taxpayer or the joint lives of the taxpayer and his/her beneficiary by the use of
Life Insurance Transfer for Value Rule
A life insurance policy may be transferred to another person in exchange for a valuable
consideration. The tax-exempt status of the death proceeds is then lost unless the transfer
is to a spouse or business partner presently engaged in business with the policyowner.
The Internal Revenue code clearly states the death benefit will be taxed if the policy is
transferred. The law prevents a firm from purchasing tax-exempt life proceeds and evading
If the policy is gifted, the proceeds will remain tax-exempt unless the gifting policyowner
acquired the policy by a transfer for value.
1035 Tax Free Exchange
1. Internal Revenue Code 1035 provides that no gain or loss will be recognized on
certain exchanges of contracts relating to the same insured:
a. When one life insurance policy is exchanged for another life insurance policy,
an endowment or an annuity contract (Whole Life for a Universal Life).
b. When one endowment is exchanged for another endowment that provides for
payments on or before the original endowment date. An endowment may be
exchanged for an annuity contract, but the IRC 1035 does not authorize the
exchange of endowments for any life insurance policy.
c. When exchanging annuity contracts within the same company the owner is
attempting to achieve a better interest rate. Tax deferment continues throughout
2. A 1035 exchange is actually the assignment by the original insurer to the replacing insurer.
3. This process allows for the assets of one annuity/insurance policy to be transferred to
another and continue the tax-deferred status of the invested funds.
Taxation of Annuities:
Accumulation and Annuity Phases
– interest earned during the accumulation
period is not taxable until annuitization begins and the annuitant starts receiving benefits.
Upon receipt of benefits, an annuitant is taxed on the amount of earned interest, not the
principal. The percentage of principal to interest determines the exclusion ratio.
a. If an annuity is surrendered, any amount received over the cost basis must be
reported and is taxed as ordinary income.
b. When the annuitant begins receiving distribution payments of principal and
interest, the taxation of these payments depends upon the type of annuity option
selected for the distribution.
Taxation of Annuities:
Distributions at Death
– if the decedent’s annuity payments ceased upon death,
nothing is included in the gross estate.
a. If annuity payments are to continue to another person upon an annuitant’s death,
the survivor’s proceeds are included in the gross estate.
b. When a lump sum is paid, to a beneficiary during either phase of an annuity,
that portion of benefit that exceeds the total contributions of the owner must be
reported as income to the IRS.
Taxation of Annuities:
The Deceased’s Estate
the value of an annuity or other payments received under an individual retirement account (IRA) by a beneficiary are to be included in the decedent’s
Non-Tax Qualified Deferred Compensation Plans
1. A non-tax qualified deferred compensation plan is any employer provided retirement
plan that does not comply with the ERISA requirements that apply to qualified plans.
2. Non-tax qualified deferred compensation plans are most commonly used when an
employer wants to select certain key employees for which to provide a retirement plan.
3. The employer is not entitled to deduct contributions to the plan until the year in which a
covered employee receives income from the plan. The employer’s cost basis is equal to premiums paid.
4. Earnings in the plan are tax deferred to the employee until he/she receives income from
Defined Benefit Plan
a qualified pension plan that guarantees a specified level
benefit at retirement. A defined benefit plan must pass a minimum participation test;
the lesser of 50 employees or 40% of all the employees of that employer, this is referred
to as the (50–40) test.
Defined Contribution Plan
– any type of retirement plan that is based solely on the
amount of contributions made to the plan. The benefits are not determined until the date
Tax Reform Act of 1986
states no more than $200,000 of compensation shall be used
to calculate either a Defined Benefit or Contribution Retirement Plan.
Employee Retirement Income Security Act (ERISA)
The Employee Retirement Income Security Act of 1974 (ERISA) provided provisions
pertaining to participating, vesting and funding which will influence every aspect of
retirement plans. The legal and tax details are extremely complex and beyond the scope of
this course, however, some of the key elements of a plan are listed:
1. Determine eligibility and apply the nondiscrimination requirements regarding age and sex.
2. Normal retirement age is essential in estimating costs.
3. Benefit formula is commonly 50% to 70% of the employees’ average compensation in
the five to ten years immediately before retirement.
4. Maximum benefits are required in plans when benefits for key employees might be
greater than for other employees.
5. Supplemental benefits are those such as death, disability and other authorized
withdrawals of benefits during the pre-retirement period.
6. Employee contributions must be determined to be contributory or noncontributory.
7. Vesting allows the employee to be able to withdraw all contributions plus interest if
he/she discontinues employment. The longer an employee stays with the company, the
greater the percentage of funds “vested.”
8. Alienation of Benefits – the plan may not distribute, segregate, or otherwise
attach any portion of participants’ benefits in favor of the participant’s spouse, or former
spouse, unless it is mandated by a qualified domestic relations order.
9. The trustee of a retirement fund must ignore any claims of indebtedness received on
behalf of an employee unless it is from the IRS in relation to delinquent taxes, then the
claim must be honored.
10. A plan is considered Top Heavy when the accrued benefits of certain officers, owners,
key employees, and the beneficiaries exceeds 60% of the total accrued value of the
plan. A Top Heavy plan must be adjusted to comply with IRS code.
ERISA Fiduciary, Reporting and Disclosure Requirements
1. The Department of Labor has determined that a plan administrator automatically has
the fiduciary responsibility for the plan. An insurer, third party administrator or an
employer may be assigned as plan administrator, but the agent soliciting the plan and
earning commissions cannot be.
2. The administrator is responsible for filing all reports and disclosures with the
Department of Labor.
Following are the five required reports:
a. Summary plan description – the initial report at installation must contain
the name of the plan address, employer’s tax identification number, the plan’s
fiscal year dates, the name of the plan administrator and his/her business phone
b. Annual reports – must be filed by the last day of the seventh month following
the end of each fiscal year of the plan.
c. Notice of Material Modifications – must be completed within 30 days of
receiving a Department of Labor request for this report. A $10 per day fine will
be assessed for each day the report is late up to $1,000.
d. Terminal Report – the administrator of any terminating defined benefit plan
must file a termination report with the Secretary of Labor and the Pension
Benefit Guaranty Corporation.
e. Notice of Amendments – plan amendments which reduce accrued benefits
of a participant may not take effect unless the administrator has filed a notice of
amendment with the Department of Labor.
Qualified Retirement Plans
These plans must meet certain qualifications set by Congress that allows them to have
certain tax advantages. Established for the exclusive benefit of a firm’s employees, the
plan must be formed by written agreement and cannot discriminate in favor of any highly
compensated employee(s). Removing money from any of these retirement plans would
result in an IRS penalty tax if the withdrawal is not a rollover or the action is taken before
the person is age 59 ½.
1. Incidental limitation is the maximum amount of life insurance that may be purchased by
a qualified plan on the life of a plan participant.
2. A qualified plan must exist primarily for the purpose of providing a retirement benefit;
any life insurance in the plan must be “incidental.”
Savings Incentive Match Plan for Employees (S.I.M.P.L.E.)
a. Must be the only type of retirement plan the firm has available for the
employees, except a Deferred Compensation 457 Plan.
b. May be written as an IRA or 401(K).
c. The organization must have 100 employees or less, each earning at least $5,000
d. Payroll deductions are expressed as a percentage of compensation and may not
exceed $10,000 annually indexed for inflation.
e. Employer must match up to 3% of the employee elective contributions or
contribute 2% of nonelective contributions in behalf of each group member.
f. Vesting is 100% immediately, with a 25% penalty for premature withdrawals
the first two years.
g. Employees who are age 70 ½ or older may participate.
h. Neither the SIMPLE IRA or 401(K) require the participant to meet the ADP test
(actual deferred percentage).
i. The maximum contributions are indexed to the cost of living.
j. The advantage of a SIMPLE is the elimination of high administrative costs.
Simplified Employee Pensions (SEPs)
a. The employer may contribute to employee’s IRA and deduct it as a business
b. These contributions are taxable as income to the employee upon receipt at
c. Annuities are commonly the funding medium used.
Self-Employed Plans (HR 10 or KEOGH Plans)
a. These are plans in which a self-employed individual may contribute part of his/
her earned income into a retirement plan and deduct those contributions from
present taxable income.
b. Any self-employed individual having employees who meet certain
qualifications must also contribute to a retirement plan for those employees.
Profit-Sharing and 401(K) Plans
a. 401(K) Plans are profit-sharing plans allowing an employee a choice between
taking income in cash or putting the income into a qualified plan and deferring
that portion of income.
b. Rollover transfers between qualified plans on a “trustee-to-trustee” basis will
avoid mandatory income tax withholding. If the transfer is trustee-to-employeeto-
trustee, a 20% tax must be paid and only the 80% is the rollover amount,
with income taxes due on the full amount.
Employee Stock Ownership Plan (ESOP)
- A qualified defined contribution plan
with benefits distributed in the form of employer stock.
Section 457 Deferred Compensation
a. Employees of states, counties, and municipalities may set up an arrangement
where the employer agrees with each employee to reduce his/her pay by a
specified amount and to invest the deferrals in one or more investments for the
b. These amounts will be distributed to the employee upon death, retirement, or
c. Deferred annuities are a popular investment for these types of plans.
403(b) Tax-Sheltered Annuities (TSAs)
a. Employees of nonprofit organizations IRC Sec 501(c) (3) and public schools
IRC Sec 403(b) may have an arrangement with the employer whereby the
employer agrees with each participating employee to reduce his/her pay by a
specified amount and invest it in a retirement fund or contract for the employee.
Employees do not make direct payments to the retirement fund.
b. These accounts are owned by the employee and are nonforfeitable and will be
paid upon death, retirement, or termination of the employee.
c. All monies invested and the interest accumulations are tax-deferred until received.
Individual Retirement Accounts (IRAs)
Anyone under the age of 70 ½ who has earned income may open an IRA. Contributions
grow tax-free until they are withdrawn. The maximum annual contribution allowed by the
IRS is $4,000. Unlike nonqualified annuities, but like all qualified plans, all annuitization
benefits are normally taxed.
a. Distributions – payments from the account must start by age 70 ½ or incur a
50% excise tax.
b. Premature Distributions – withdrawals before age 59 ½ will incur a 10%
c. Rollover – changing from one type of qualified plan to another. IRS rollover
guidelines permit a rollover to avoid taxation as an early withdrawal. Rollovers
must be completed within a 60-day window. A direct rollover is from trustee
to trustee (nontaxable). Fund amounts are not a factor, but trustee-to-ownerto-
trustee rollovers are subject to taxation at 20% if rolled from a qualified
retirement plan or a TSA. Rollovers between IRA’s are subject to elective
1) You cannot roll over an individual or Roth IRA into a 401(K) plan, but you
can roll a retirement fund into an IRA (buy out, resignation etc.).
2) Any amount rolled over to an IRA is not taxable, but any of the funds used by
the owner during this transaction is taxable.
d. IRAs may be funded using mutual funds, common stock, certificates of deposit,
or annuities; but not life insurance. Life insurance does not meet the IRS
qualifications of an IRA.
e. An annuitant may take an early withdrawal from an individual retirement
account without fear of a penalty tax when certain qualified events occur, such
1) Long term disability.
2) Qualified first time homebuyer.
3) Medical expenses are excessive and without a prognosis of recovery.
a. A retirement account that is set up by an employer for its employees.
b. The plan must be funded, meaning the benefits are payable out of funds
(insurance or annuities) specifically set aside in advance.
c. All qualified pension plans must have an established vesting schedule.
IRS Requirements of Tax Qualified Plans
1. There must be a minimum level of participation and vesting stated in the contract.
2. All benefits remain equal or improve upon any merger of two or more plans.
3. When a participant may begin receiving distribution from the plan must be stated in the contract.
4. Limitations of benefits both minimums and maximums must be stated at the beginning of
5. Benefits may not be reduced by any social security retirement benefit.
6. Must provide either a joint and survivor or survivor benefit for the participant and his/her
7. Procedures for a claims review must be available both to the participant and his/her beneficiary.
Costs of Life Insurance on Qualified and Profit
Some retirement and profit sharing retirement plans have a fringe benefit of life insurance.
The purpose of this coverage is to provide dependents with an amount calculated to equal a
future gross retirement benefit should the covered employee die prematurely. Some of the
responsibilities and characteristics of these benefits are as follows:
1. If the premium for this life insurance is paid on a noncontributory basis, the premium is
taxable as income to the employee for the year in which the premiums were paid.
2. When the plan is insured by a term policy, the full amount of premium is reported as
3. The IRS uses a rate table for the insurance plans that are other than term insurance. The
rating tables are referred to as P.S. 58 Tables.
a. When the amount of employer contribution is known, the table reflects the
portion of the contribution that would normally be paid in insurance premium.
b. Once the premium is calculated by using the P.S. 58 Tables, that amount is
reported on the employee’s W-2 form and is taxed as ordinary income.
– the Roth IRA was established under the Tax Relief Act of 1997. The Roth
IRA is a nondeductible tax-free retirement plan. Developed primarily for single people
with income levels below $95,000 and married couples filing jointly with a combined
income below $150,000. Single individuals with incomes between $95,000 and $110,000
and married couples with incomes between $$150,000 and $160,000 may make a reduced
contribution to their Roth IRAs. Those with incomes over the limits (currently $110,000
for single, $160,000 for married) cannot contribute to a Roth IRA. Contributions may be
limited due to amounts of income. There is a maximum contribution per year. If married,
an additional spousal contribution may also be made if only one has income and the couple
file taxes jointly. If a person owns a traditional IRA and a Roth IRA, the total contribution to
both cannot exceed the annual maximum contribution of a single IRA. This same rule applies
if the annuity owner is involved with a retirement plan at work. This is in accordance with IRC Sec 408 A (d).
Taxation of the Roth IRA
1. Any traditional IRA converted to the Roth IRA will be taxed as ordinary income in that year.
2. After 5 years & age 59 ½, proceeds may be received tax free to those who qualify.
3. Contributions are not tax deductible as with a traditional IRA.
(Roth) IRA - Distribution of Proceeds
– with the 1997 Tax Relief Act both the traditional IRA and the
Roth IRA have two penalty-free lump sum distributions. These distributions are:
1. For qualified first time homebuyers $10,000 maximum.
2. Qualified tuition for higher education. This is presently without limitations when paying
only the tuition charges on an annual basis.
IRA - Owner Benefits
– there are many owners’ benefits with the following being the most distinct.
1. The contribution period may exceed age 70 ½.
2. The IRS code pertaining to the minimum distribution of IRA’s does not apply.
3. Qualifying annuitants receive distributions tax free.