L6. Federal Tax Considerations

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  1. Upon death, all of the following taxes could apply, EXCEPT:
    A) Luxury tax
    B) Estate tax
    C) Income tax
    D) Inheritance tax
    • A) Luxury tax
    • Explanation: (Federal Tax Considerations)
    • Luxury taxes are not levied upon death, although all of the other taxes listed may apply.
  2. Which of the following is true when a person with an IRA dies and their surviving spouse is the beneficiary:
    A) 100% of the distribution is taxable to the beneficiary in the year the owner died
    B) Capital gains taxes are due on the amount of the distribution
    C) The distribution is tax free
    D) The spouse is entitled to the marital deduction
    • D) The spouse is entitled to the marital deduction
    • Explanation: (Federal Tax Considerations) When an IRA participant dies before required minimum distributions start and their surviving spouse is listed as beneficiary, the spouse may take the entire distribution within five years of the account owner's death or treat the IRA as their own and delay distributions until they reach age 70 1/2. In either event, ordinary income taxes will eventually apply.However, although the value of the IRA is included in the value of the account owner's estate at death, under the estate tax "marital deduction," the entire estate will pass to the surviving spouse with no estate taxes due until the surviving spouse eventually dies.
  3. On IRAs, the 10% early withdrawal penalty that applies to distributions taken prior to age 59 1/2 is waived in all of the following situations, EXCEPT:
    A) First time home buyer expenses
    B) Bankruptcy
    C) Medical expenses
    D) Disability
    • B) Bankruptcy
    • Explanation: (Federal Tax Considerations)
    • The IRS levies a 10% IRS early withdrawal penalty on distributions taken from IRAs by an individual under age 59 1/2. However, this penalty is waived under certain circumstances, such as distributions due to: death of the IRA owner, disability of the IRA owner, medical expenses that exceed 10% of the individual's adjusted gross income, made to an IRA owner who is unemployed for payment of health insurance premiums, made for qualified higher education expenses for the IRA owner, the IRA owner's spouse, or children or grandchildren of either, made for first time home buyer expense ($10,000 lifetime limit), but NOT for bankruptcy.
  4. Regarding the rules applicable to Modified Endowment Contracts (MECs), if a "material change" to an existing whole life insurance policy occurs:
    A) The policy will be considered to be surrendered
    B) The IRS will consider a 1035 exchange to have occurred
    C) The seven-pay test will be applied again
    D) The policy will be considered to be a security
    • C) The seven-pay test will be applied again
    • Explanation: (Federal Tax Considerations)
    • To determine whether or not a policy is a Modified Endowment Contract (MEC), the seven-pay test is administered when the policy is first issued. However, even though the policy was not initially determined to be an MEC, the seven-pay test will be administered again whenever a "material" change, such as a substantial increase in the cash value, takes place. Remember, a whole life policy could lose its favorable tax treatment as life insurance if its "risk corridor" (the difference between the policy limit and the cash value) does not satisfy IRS rules.
  5. A 35-year-old client who has contributed $20,000 to their ROTH IRA over a period of time now has an account balance of $30,000. How much can they withdraw without tax or penalty:
    A) $20,000
    B) $30,000
    C) $10,000
    D) None
    • A) $20,000
    • Explanation: (Federal Tax Considerations)
    • Since contributions to a ROTH IRA are never tax deductible, the client's cost basis consists of the amount of after-tax dollars they contributed, which in this case was $20,000. IRS rules state that on a ROTH, a client may withdraw the amount of after-tax dollars they invested at any time, without tax or penalty.
  6. The gift of a life insurance policy to a charity:
    A) Does not create any tax deductions
    B) May be accomplished by designating the charity as revocable beneficiary
    C) Creates an income tax deduction at the time of death
    D) Creates an income tax deduction at the time of the gift
    • D) Creates an income tax deduction at the time of the gift
    • Explanation: (Federal Tax Considerations)
    • When a policy owner gifts their life insurance to a charity, they are entitled to a current income tax charitable deduction. The deduction is limited to the policy owner's cost basis in the policy, which is generally the amount of premiums they have paid in to date.
  7. A client contributed $20,000 to a non-qualified tax-deferred annuity over a period of time, which has now grown to $30,000 due to interest earnings that were credited to the account. If the client, who is now age 45, wants to take cash surrender, what will be their tax implication:
    A) $10,000 capital gain
    B) $10,000 ordinary income
    C) $10,000 capital gain, $20,000 ordinary income
    D) $10,000 ordinary income, plus a 10% penalty
    • D) $10,000 ordinary income, plus a 10% penalty
    • Explanation: (Federal Tax Considerations)
    • On the cash surrender of an annuity, that portion that is withdrawn that is above the client's cost basis is taxable as ordinary income, so in this case the client would have to pay ordinary income taxes on the $10,000 in interest earnings, plus a 10% penalty since they are only age 45. Cost basis is defined as the amount of money invested that the client has already paid tax on.
  8. All of the following are true regarding modified endowment contracts (MECs), EXCEPT:
    A) They lose their favorable tax treatment as life insurance
    B) Their cash value builds too fast
    C) It is unlawful to sell them
    D) The IRS considers them to be a type of investment product
    • C) It is unlawful to sell them
    • Explanation: (Federal Tax Considerations)
    • Although no one really wants to buy an MEC, they are not unlawful.
  9. Earned income is required to contribute to all of the following, EXCEPT:
    A) Traditional IRA
    B) Roth IRA
    C) 403b
    D) Variable annuity
    • D) Variable annuity
    • Explanation: (Federal Tax Considerations)
    • Earned income is not required in order to contribute to a variable annuity.
  10. A client with a $300,000 Modified Endowment Contract (MEC) paid in $70,000 in premiums. Their cash value is now $100,000. If they take cash surrender what percentage of the distribution is taxed as ordinary income?
    A) 100%
    B) 30%
    C) 70%
    D) 0%, since MEC distributions are taxed as capital gains
    • B) 30%
    • Explanation: (Federal Tax Considerations) MECs have tax implications that differ from other types of life insurance policies. MECs are policies that fail the seven-pay test, which means that the cash value is building too rapidly within the policy. Once a policy is classified as a MEC it will remain a MEC for the life of the contract. In general, when an insured takes cash surrender of a life insurance policy they are only taxed to the extent that the amount they withdraw exceeds the amount they paid in, since life insurance cash surrenders are taxed first-in-first-out (FIFO). However, MEC distributions are taxed as a withdrawal of interest first and return of premium second, or last-in-first-out (LIFO). MECs are also subject to a 10% penalty tax on the interest withdrawn, if taken when the insured is under age 59 1/2. Since this question does not mention age, we can assume the insured is older than 59 1/2.Since the insured is taking a full cash surrender, they would only have to pay ordinary income tax on the interest they are withdrawing ($30,000), which equals 30% of the total amount withdrawn ($100,000). However, using the same numbers in this question, if the insured instead took a partial withdrawal of $30,000 from the MEC, 100% of the distribution ($30,000) would be taxable.
  11. On a cash value life insurance policy, a "material change" could cause the seven-pay test to apply again which could result in the policy being classified as a:
    A) Universal life policy
    B) Modified premium policy
    C) Modified Endowment Contract
    D) Variable life policy
    • C) Modified Endowment Contract
    • Explanation: (Federal Tax Considerations)
    • Cash value life insurance policies that fail the seven-pay test, which is administered when the policy is first issued, are considered to be Modified Endowment Contracts (MECs) and as such lose some of their favorable tax treatment. Although a policy may initially pass the seven-pay test, making a "material change" to the policy later on could cause the seven-pay test to be administered again, thereby causing the policy to be considered an MEC from that point on. A "material change" is defined as any increase in the death benefit under the contract.
  12. When a customer takes cash surrender and then transfers their policy to another insurance company in order to defer tax, it is referred to as a:
    A) Absolute assignment
    B) 1035 exchange
    C) Viatical settlement
    D) Collateral assignment
    • B) 1035 exchange
    • Explanation: (Federal Tax Considerations)
    • A 1035 exchange is very similar to a rollover of a qualified plan. If an insured takes cash surrender of their life insurance policy or annuity they must pay ordinary income tax on any interest they received. The IRS will allow the insured/annuitant to defer paying this tax if they execute a 1035 exchange. The 1035 exchange guidelines state that the new life insurance policy must be written on the life of the same person and the new annuity benefits must be payable to the same person. The exchange does not have to be done with the same insurance company, and there is no limit on the amount that can be exchanged. Certain exchanges are not allowed, such as an exchange of an annuity for a life insurance policy. This is not an allowable 1035 exchange since it will put the individual in a better tax position (annuity death benefits are taxable and life insurance death benefits are not). 1035 exchanges are usually utilized to obtain a policy with a higher rate of return. A viatical settlement is utilized when a terminally ill insured sells their life insurance policy to an investor for cash.
  13. The spousal beneficiary of an IRA owner who dies must start withdrawals no later than:
    A) Within 5 years of the date that the owner died
    B) April 1st of the year after the owner would have reached age 70 1/2
    C) April 1st of the year after they reach age 70 1/2
    D) By December 31 of the year that the owner died
    • C) April 1st of the year after they reach age 70 1/2
    • Explanation: (Federal Tax Considerations)
    • Although spousal beneficiaries on an IRA may make withdrawals sooner, they must start withdrawals no later than April 1st of the year after they turn age 70 1/2.
  14. If an annuitant dies during the accumulation period their beneficiary would receive which of the following:
    A) The total sum of the premiums paid in or the cash value of the contract, whichever is less
    B) Annuities do not contain a death benefit
    C) The total sum of the premiums paid in or the cash value of the contract, whichever is greater
    D) 50% of the value of the account
    • C) The total sum of the premiums paid in or the cash value of the contract, whichever is greater
    • Explanation: (Federal Tax Considerations)
    • Although annuities do not offer life insurance protection, they do contain a death benefit, which consists of the amount of premiums paid, or the cash value in the contract, whichever is more.
  15. The maximum lifetime distribution that can be made from an IRA for qualified first-time home buyer expenses without incurring a 10% premature distribution penalty is:
    A) $10,000
    B) $25,000
    C) $20,000
    D) $15,000
    • A) $10,000
    • Explanation: (Federal Tax Considerations)
    • The maximum lifetime distribution that can be made from an IRA for qualified first-time home buyer expenses is $10,000. Although such distributions are taxable, the 10% premature distribution penalty is waived.
  16. If a client makes an IRC Section 1035 exchange, what are the tax implications when the second policy is surrendered for cash:
    A) Ordinary income
    B) Tax deferral
    C) No taxes are due
    D) Capital gain
    • A) Ordinary income
    • Explanation: (Federal Tax Considerations)
    • An Internal Revenue Code Section 1035 exchange does not avoid taxes, it just defers them until the second policy is surrendered. When the second policy is surrendered for more than the client's original cost basis, any gain is taxable as ordinary income. Life insurance products and retirement plans are not eligible for capital gain tax treatment.
  17. If a distribution is taken from a deductible IRA to pay for qualified higher education expenses, the distribution is:
    A) Not subject to penalties or taxes
    B) Subject to income taxes, but not a 10% premature distribution penalty
    C) Not subject to income taxes
    D) Subject to a 10% premature distribution penalty, but not income taxes
    • B) Subject to income taxes, but not a 10% premature distribution penalty
    • Explanation: (Federal Tax Considerations)
    • Distributions made from a tax deductible IRA to pay for qualified higher education expenses are taxable, but the 10% premature distribution penalty is waived.
  18. A client contributed $20,000 cash to purchase a non-qualified Single Premium Deferred Annuity years ago, which has now grown to $50,000 due to interest earnings that were credited to the account. If the client is now age 60 and annuitizes over their 20-year life span, how much of their income from this annuity will be excluded from taxes each year for the next 20 years:
    A) $1,000
    B) $2,500
    C) $1,500
    D) None
    • A) $1,000
    • Explanation: (Federal Tax Considerations)
    • This is an example of how the annuity "exclusion ratio" works. Since this annuity was purchased with after-tax dollars, the client's "cost basis" consists of the entire amount invested, which in this case was $20,000. When they annuitize the contract, their cost basis will be returned to them as a tax-free return of principal over their life span. Since they have a 20-year life span, they will receive $1,000 a year tax-free. Anything they receive over that amount will be considered to be interest earnings and will be taxable as ordinary income.
  19. Premiums paid by an employer for group life insurance are taxable to an employee in amounts in excess of:
    A) $40,000
    B) $50,000
    C) $20,000
    D) $30,000
    • B) $50,000
    • Explanation: (Federal Tax Considerations)
    • IRS rules specify the premium cost for the first $50,000 of life insurance coverage provided under an employer-provided group term life insurance plan does not have to be reported as income and is not taxed to an employee. However, amounts in excess of $50,000 paid for an employee by an employer will trigger taxable income for the "economic value" of the coverage provided to the employee.
  20. All of the following are true regarding IRC Section 1035 exchanges, EXCEPT:
    A) A life insurance policy may be exchanged for an annuity
    B) A variable annuity may be exchanged for a fixed annuity
    C) Qualified exchanges will avoid future taxes
    D) Exchanges do not have to be made with the same insurer
    • C) Qualified exchanges will avoid future taxes
    • Explanation: (Federal Tax Considerations)
    • On an IRC Section 1035 exchange, taxes are deferred until the second policy is surrendered, but they are not avoided. The rules state that an exchange may be made with the same insurance company or a different company, but if the exchange involves life insurance, both policies must be on the life of the same person. Life insurance may be exchanged for life insurance or annuities, and annuities may be exchanged for other annuities, but annuities may not be exchanged for life insurance.
  21. A client pays $4,000 in premiums on their $50,000 Whole Life policy that has a cash value of $5,000. If they take cash surrender, their tax implication will be:
    A) $5,000 capital gains
    B) $1,000 capital gains
    C) $5,000 ordinary income
    D) $1,000 ordinary income
    • D) $1,000 ordinary income
    • Explanation: (Federal Tax Considerations)
    • When taking cash surrender the insured only has to pay tax on the amount withdrawn that exceeds the amount that they paid in. Since premiums for individual life insurance are paid with after tax money, the premiums paid represent the insured's cost basis. When withdrawn, the cost basis is returned to the insured without tax. When taking cash surrender the IRS treats the distribution as return of cost basis first and interest second (First-In-First-Out or FIFO). Since the insured paid $4,000 in premiums and they are withdrawing $5,000 they would have to pay ordinary income tax on the difference ($5,000-$4,000=$1,000). There are never capital gains tax on life insurance cash surrenders.
  22. If a policy owner who paid $10,000 in premiums into a whole life policy now surrenders the policy for its $12,000 cash value, what are the tax implications:
    A) $12,000 is taxable as ordinary income
    B) $10,000 is tax free and $2,000 is taxable as ordinary income
    C) $12,000 is taxable as a capital gain
    D) None, since life insurance proceeds are not taxable
    • B) $10,000 is tax free and $2,000 is taxable as ordinary income
    • Explanation: (Federal Tax Considerations)
    • Cash surrenders of life insurance policies will generate taxable income to the policy owner only to the extent that the cash surrender value exceeds the amount of premiums paid in. In this case, the $2,000 excess would be taxable as ordinary income.
  23. A client contributed $20,000 to a non-qualified tax-deferred annuity over a period of time, which has now grown to $30,000 due to interest earnings that were credited to the account. If the client, who is now age 45, wants to take a partial withdrawal of $5,000, what will be their tax implication:
    A) None, since they are withdrawing less than the amount that they have contributed
    B) $5,000 capital gain
    C) $5,000 ordinary income
    D) $5,000 ordinary income, plus a 10% penalty
    • D) $5,000 ordinary income, plus a 10% penalty
    • Explanation: (Federal Tax Considerations)
    • On partial withdrawals from annuities, the first money out is considered to be the interest earnings, so in this case, the entire $5,000 would be taxable as ordinary income. In addition, since the client is under age 59 1/2, a 10% premature distribution penalty would also be levied by the IRS.
  24. Proceeds of a life insurance policy paid to a beneficiary:
    A) Are taxable
    B) Avoid probate
    C) May be assigned prior to receipt
    D) Are not included in the insured's estate
    • B) Avoid probate
    • Explanation: (Federal Tax Considerations)
    • Although the amount of life insurance that a customer has is included in the value of their estate upon death, the proceeds payable to a designated beneficiary are paid free of taxes and probate. If there is no designated beneficiary, the proceeds will be payable to the insured's estate, which is subject to probate, and their assets will be distributed according to the terms of their will, if any.
  25. If an IRA participant dies before distributions begin, their surviving spouse as beneficiary:
    A) Must take the funds out over the owner's expected life span
    B) Must take the funds out within five years of the death of the owner
    C) Must take the funds out over their expected life span
    D) May roll the account over to another IRA
    • D) May roll the account over to another IRA
    • Explanation: (Federal Tax Considerations)
    • Generally, when an IRA owner dies before distributions begin, distributions must be made under either the life expectancy method or the five-year rule. However, when a surviving spouse is the sole designated beneficiary of the IRA, they may elect to treat the IRA as their own and may either continue the account as owner or roll it over to their own IRA account.
  26. A ROTH IRA is purchased with:
    A) Voluntary after-tax contributions
    B) Voluntary before-tax contributions
    C) Involuntary before-tax contributions
    D) Involuntary after-tax contributions
    • A) Voluntary after-tax contributions
    • Explanation: (Federal Tax Considerations)
    • Individual contributions to a ROTH IRA are voluntary and are not tax-deductible.
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L6. Federal Tax Considerations
Updated:
2016-03-21 18:37:14
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Federal Tax Considerations
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