FiCEP Taxes and Insurance 6

Question 1

A client receives a $15,000 life insurance settlement from a policy owned by their employer, where the employer was also the beneficiary but then assigned the proceeds to the employee. Under IRS transfer-for-value rules, how are the proceeds taxed?

Accepted Answer

The full $15,000 is taxable as ordinary income because the transfer-for-value rule was triggered

Answer

The transfer-for-value rule under IRC §101(a)(2) removes the income exclusion for life insurance proceeds when a policy is transferred for valuable consideration. When an employer assigns proceeds to the employee as compensation, this constitutes a transfer for value, making the entire $15,000 taxable as ordinary income. Exceptions exist (e.g., transfers to the insured, a partner, or a corporation), but an employee assignment by the employer does not qualify.

Question 2

A financial counseling client in the 22% federal tax bracket withdraws $10,000 from a traditional IRA at age 55 after being separated from service. They believe no early withdrawal penalty applies. Which statement is most accurate?

Accepted Answer

A 10% early withdrawal penalty applies because the age-55 exception under IRC §72(t) applies only to qualified employer plans, not IRAs

Answer

The age-55 separation-from-service exception (IRC §72(t)(2)(A)(v)) applies exclusively to distributions from qualified employer-sponsored plans (401(k), 403(b), etc.) when the employee separates from service in or after the year they turn 55. This exception does NOT extend to IRAs. IRA withdrawals before age 59½ are subject to the 10% penalty unless a different exception applies (e.g., substantially equal periodic payments, disability, or first-time home purchase up to $10,000).

Question 3

A client has a whole life insurance policy with a cash value of $40,000 and a cost basis (premiums paid) of $25,000. They take a policy loan of $12,000 and the policy subsequently lapses. What are the tax consequences?

Accepted Answer

The client recognizes $15,000 of ordinary income (cash value minus basis) because the lapse is treated as a surrender

Answer

When a life insurance policy lapses with an outstanding loan, the IRS treats the lapse as a deemed distribution equal to the policy's entire cash value. The taxable amount is the excess of the cash value ($40,000) over the cost basis ($25,000) = $15,000 of ordinary income, regardless of the loan amount. The loan itself is not the taxable event — it is the lapse that triggers recognition. This is a common surprise for clients who assumed their loan was not taxable.

Question 4

Under the Affordable Care Act, a married couple files separately and one spouse receives advance premium tax credits (APTC) through the Marketplace. What is the tax consequence at filing?

Accepted Answer

They must repay all advance premium tax credits received, with no income-based repayment cap

Answer

Married taxpayers who file separately are generally ineligible for the premium tax credit under IRC §36B. When a couple files separately and one spouse received APTC during the year, the receiving spouse must repay the entire amount of advance payments on Form 8962 — the repayment cap that applies to other filers does NOT apply to married-filing-separately filers (except in limited domestic abuse or abandonment situations). This is a critical planning consideration for clients who choose or are forced to file separately.

Question 5

A client owns a rental property and also works as a real estate agent full-time (qualifying as a real estate professional under IRC §469). Their rental activities generate a $28,000 loss. Their AGI is $180,000. How can this loss be treated?

Accepted Answer

The full $28,000 is deductible against ordinary income because qualifying as a real estate professional removes the passive activity limitation on rental losses

Answer

Under IRC §469(c)(7), a taxpayer who qualifies as a real estate professional — meaning more than 50% of personal services are in real property trades or businesses AND more than 750 hours per year are spent in those activities — can treat rental activities in which they materially participate as non-passive. This means the $28,000 rental loss is fully deductible against ordinary income with no AGI-based phase-out. The $25,000 passive loss allowance (which phases out between $100k–$150k AGI) is irrelevant once real estate professional status is achieved, because the losses are no longer passive.

FiCEP - Financial Counseling Certification Program Practice Test

FiCEP - Financial Counseling Certification Program Practice Test

FiCEP Taxes and Insurance 6