CLU Individual Life Insurance Planning 5 — Questions and Answers
Question 1: Under the IRC Section 101(a) general rule, how is a life insurance death benefit treated for federal income tax purposes when paid to a named beneficiary?
- Fully taxable as ordinary income
- Excluded from the beneficiary's gross income (Correct answer)
- Taxable only on gains above the policy's cost basis
- Subject to capital gains tax
Correct answer: Excluded from the beneficiary's gross income
IRC §101(a) generally excludes life insurance death benefits from federal income tax when paid by reason of death of the insured.
Question 2: A 'transfer for value' rule violation causes which portion of a life insurance death benefit to become taxable?
- The entire death benefit is taxable as ordinary income
- Only the amount received in excess of the value paid for the policy plus subsequent premiums paid is taxable (Correct answer)
- Only the original policy face amount is taxable
- The death benefit is taxable as a capital gain
Correct answer: Only the amount received in excess of the value paid for the policy plus subsequent premiums paid is taxable
When a policy is transferred for valuable consideration, the death benefit exceeding the buyer's investment (amount paid plus premiums paid after transfer) loses its income-tax exclusion.
Question 3: Which of the following transfers of a life insurance policy is an exception to the transfer for value rule?
- A transfer to an unrelated business partner
- A transfer to the insured (Correct answer)
- A transfer to a trust for the insured's children
- A sale to an investor group
Correct answer: A transfer to the insured
Transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, and to a corporation in which the insured is a shareholder or officer are excepted from the transfer for value rule.
Question 4: What is the primary function of an irrevocable life insurance trust (ILIT) in estate planning?
- To make life insurance premiums tax-deductible
- To keep life insurance proceeds out of the insured's taxable estate (Correct answer)
- To allow the insured to borrow from the policy tax-free
- To allow heirs to receive benefits during the insured's lifetime
Correct answer: To keep life insurance proceeds out of the insured's taxable estate
An ILIT owns the life insurance policy so that, if properly structured, the death proceeds are excluded from the grantor's gross estate under IRC §2042.
Question 5: A client age 62 is considering a 1035 exchange. Which statement about IRC Section 1035 exchanges is CORRECT?
- A 1035 exchange triggers immediate taxation on all policy gains
- A life insurance policy can be exchanged tax-free for another life insurance policy or an annuity (Correct answer)
- An annuity can be exchanged tax-free for a life insurance policy
- Term insurance cannot be exchanged under Section 1035 for any reason
Correct answer: A life insurance policy can be exchanged tax-free for another life insurance policy or an annuity
IRC §1035 allows a tax-free exchange of a life insurance policy for another life insurance policy, an endowment, or an annuity, but not the reverse (annuity to life insurance).
Question 6: Under the 'Goodman triangle' (unholy trinity), an estate planning problem arises when which three parties are all different individuals?
- Insured, beneficiary, and insurer
- Policyowner, insured, and beneficiary (Correct answer)
- Trustee, beneficiary, and grantor
- Agent, policyowner, and insured
Correct answer: Policyowner, insured, and beneficiary
When the policyowner, insured, and beneficiary are three different people, the death benefit may be treated as a taxable gift from the policyowner to the beneficiary.
Question 7: A client's $250,000 whole life policy has accumulated $60,000 in dividends left on deposit with the insurer. If the insured dies, the total death benefit paid will be:
- $250,000 only
- $310,000 ($250,000 face amount plus $60,000 dividends on deposit) (Correct answer)
- $190,000 ($250,000 minus $60,000)
- $250,000 minus any outstanding loans plus interest
Correct answer: $310,000 ($250,000 face amount plus $60,000 dividends on deposit)
Dividends left on deposit earn interest and are paid in addition to the policy's face amount, so the total proceeds equal $250,000 + $60,000 = $310,000.
CLU Individual Life Insurance Planning 5
Under the IRC Section 101(a) general rule, how is a life insurance death benefit treated for federal income tax purposes when paid to a named beneficiary?