CLU Income Taxation Principles 3 — Questions and Answers
Question 1: Under the annuity exclusion ratio, which formula correctly determines the tax-free portion of each annuity payment?
- Investment in the contract ÷ expected return (Correct answer)
- Expected return ÷ investment in the contract
- Total payments received ÷ years of expected payments
- Surrender value ÷ total premiums paid
Correct answer: Investment in the contract ÷ expected return
The exclusion ratio is the investment in the contract (cost basis) divided by the expected return, applied to each payment to determine the tax-free portion.
Question 2: When a nonqualified annuity owner dies before annuitization, how are gains in the contract taxed to a non-spouse beneficiary who takes a lump sum?
- As long-term capital gains
- As ordinary income in the year received (Correct answer)
- Excluded under the Section 101(a) death benefit rule
- Spread equally over five years automatically
Correct answer: As ordinary income in the year received
Gains in a nonqualified annuity paid as a lump sum to a non-spouse beneficiary at death are taxed as ordinary income in the year received.
Question 3: Which of the following is a correct statement about the income tax treatment of disability income benefits?
- Benefits are always tax-free regardless of who paid the premium
- Employer-paid premiums cause benefits to be fully taxable to the employee (Correct answer)
- Employee-paid after-tax premiums cause benefits to be fully taxable
- Benefits are always subject to FICA taxes
Correct answer: Employer-paid premiums cause benefits to be fully taxable to the employee
When an employer pays disability insurance premiums, benefits received by the employee are fully includable in the employee's gross income.
Question 4: For income tax purposes, contributions to a Health Savings Account (HSA) made by an eligible individual are:
- Deductible only if itemized deductions exceed the standard deduction
- Deductible above-the-line regardless of whether the taxpayer itemizes (Correct answer)
- Excluded from income only if made through payroll deduction
- Subject to a 7.5% adjusted gross income floor like medical expenses
Correct answer: Deductible above-the-line regardless of whether the taxpayer itemizes
HSA contributions by eligible individuals are deductible above-the-line (for AGI), making them available even to non-itemizers.
Question 5: A business owner takes a Section 162 deduction for life insurance premiums paid on a key employee. What is the tax consequence?
- The premium is deductible and death proceeds are tax-free
- The premium is generally not deductible when the business is the beneficiary (Correct answer)
- The premium is deductible and the cash value grows tax-deferred
- The deduction is limited to $25,000 per insured per year
Correct answer: The premium is generally not deductible when the business is the beneficiary
IRC Section 264 disallows premium deductions when the business is directly or indirectly a beneficiary of the policy.
Question 6: The 'inside buildup' of cash value in a life insurance policy is best described as:
- Taxable income reportable on a Schedule B each year
- Tax-deferred growth not subject to current income tax (Correct answer)
- Tax-exempt income excluded permanently under IRC Section 101
- Taxable only when the policy matures at age 121
Correct answer: Tax-deferred growth not subject to current income tax
Cash value increases inside a life insurance policy accumulate on a tax-deferred basis, meaning they are not subject to current income tax.
Question 7: Under IRC Section 1035, a tax-free exchange can be made from a life insurance policy into which of the following?
- A mutual fund account
- An annuity contract (Correct answer)
- A Roth IRA
- A health savings account
Correct answer: An annuity contract
Section 1035 permits a tax-free exchange from a life insurance policy to an annuity contract, preserving the cost basis.
CLU Income Taxation Principles 3
Under the annuity exclusion ratio, which formula correctly determines the tax-free portion of each annuity payment?