CLU Individual Life Insurance Planning 4 — Questions and Answers
Question 1: When a life insurance policy lapses and the policyowner selects the extended term nonforfeiture option, the result is:
- A reduced paid-up whole life policy for the original face amount
- A term policy for the original face amount for a period supported by the cash value (Correct answer)
- A cash payment equal to the full surrender value
- A paid-up policy for a reduced death benefit for life
Correct answer: A term policy for the original face amount for a period supported by the cash value
Extended term uses the cash value as a single premium to purchase term insurance for the original face amount, extended for as long as the cash value supports.
Question 2: Which of the following is an advantage of using life insurance cash value for retirement supplementation compared to a traditional IRA?
- Life insurance cash value contributions are always tax-deductible
- Policy loans from life insurance are generally income-tax-free (Correct answer)
- Life insurance grows at a guaranteed higher rate than IRAs
- Life insurance is not subject to any contribution limits (unlike IRAs)
Correct answer: Policy loans from life insurance are generally income-tax-free
Policy loans from a properly structured life insurance contract are generally income-tax-free, whereas IRA withdrawals are typically taxable as ordinary income.
Question 3: Under the IRC Section 7702 definition of life insurance, what is the consequence of a policy becoming a Modified Endowment Contract (MEC)?
- The policy immediately loses its death benefit
- Loans and withdrawals become subject to income tax and a 10% penalty if taken before age 59½ (Correct answer)
- The insurer must refund all premiums paid in excess of the MEC limit
- Beneficiaries must pay income tax on the death benefit
Correct answer: Loans and withdrawals become subject to income tax and a 10% penalty if taken before age 59½
A MEC is still life insurance, but distributions (loans and withdrawals) are treated as income-first (LIFO) and subject to a 10% penalty if taken before age 59½.
Question 4: A client names a minor child as sole beneficiary of a life insurance policy. What problem may arise at claim time?
- Minors cannot receive life insurance death benefits under any circumstances
- A court-appointed guardian may be required to manage the funds until the child reaches majority (Correct answer)
- The insurer will pay the death benefit directly to the child's school
- The policy will be voided because minors cannot be named as beneficiaries
Correct answer: A court-appointed guardian may be required to manage the funds until the child reaches majority
Minors cannot legally receive large sums directly, so a court-appointed guardian or custodian is typically required to manage the proceeds, which can be costly and slow.
Question 5: The concept of 'insurable interest' in life insurance requires that the policyowner:
- Must be related by blood to the insured
- Must have a financial or emotional stake in the continued life of the insured at policy inception (Correct answer)
- Must own at least 50% of a business involving the insured
- Must have insurable interest both at inception and at the time of a claim
Correct answer: Must have a financial or emotional stake in the continued life of the insured at policy inception
Insurable interest (a financial, business, or close personal relationship) must exist at policy inception; it is not required to continue until the insured's death.
Question 6: Which type of life insurance is most suitable for covering a 15-year mortgage obligation if the primary concern is minimum cost?
- Whole life insurance
- Decreasing term insurance (Correct answer)
- Universal life insurance
- Survivorship life insurance
Correct answer: Decreasing term insurance
Decreasing term insurance provides a death benefit that declines over time, mirroring an amortizing mortgage balance, at a lower cost than level-premium alternatives.
Question 7: A client insists on being the owner, insured, AND naming their estate as beneficiary. What estate planning risk does this create?
- The death benefit will be subject to income tax
- The death benefit will be included in the insured's gross estate for federal estate tax purposes (Correct answer)
- The policy will be treated as a gift to the estate
- The insurer can refuse to pay if the estate has outstanding debts
Correct answer: The death benefit will be included in the insured's gross estate for federal estate tax purposes
When the insured holds incidents of ownership, the death benefit is includable in the gross estate under IRC §2042, potentially triggering federal estate taxes.
CLU Individual Life Insurance Planning 4
When a life insurance policy lapses and the policyowner selects the extended term nonforfeiture option, the result is: