FREE Chartered Life Underwriter (CLU) Income Taxation Principles Questions and Answers

Question 1

A client owns a life insurance policy that was overfunded in its early years, causing it to be classified as a Modified Endowment Contract (MEC).
The policy has a cash value of $150,000, a cost basis of $110,000, and an outstanding loan of $50,000.
How is the policy loan treated for income tax purposes?

Accepted Answer

The loan is treated as a distribution; $40,000 is taxable as ordinary income.

Answer

The entire $50,000 loan is treated as a tax-free return of premium.

Answer

The loan is treated as a distribution; $50,000 is taxable as a long-term capital gain.

Answer

The loan is not a taxable event because it is secured by the policy's cash value.

Question 2

A 50-year-old individual takes a $20,000 withdrawal from a non-qualified deferred annuity. At the time of withdrawal, the annuity's total value is $120,000, and the owner's cost basis (investment in the contract) is $90,000. Assuming no exceptions apply, what is the total tax impact of this withdrawal?

Accepted Answer

The entire $20,000 is taxed as ordinary income, plus a 10% penalty on the $20,000.

Answer

The $20,000 withdrawal is subject to a 10% penalty, but not ordinary income tax.

Answer

The withdrawal is a tax-free return of basis.

Answer

$15,000 is a tax-free return of basis, and $5,000 is taxed as ordinary income.

Question 3

Which of the following statements BEST describes the typical federal income tax treatment of dividends paid to a policyowner from a participating whole life insurance policy?

Accepted Answer

Dividends are treated as a tax-free return of premium until they exceed the policy's cost basis.

Answer

Dividends are always taxable as ordinary income in the year they are received.

Answer

Dividends can only be used to purchase paid-up additions and are never subject to tax.

Answer

Dividends are taxed as long-term capital gains, regardless of the amount paid in premiums.

Question 4

A client wants to replace an existing financial product with a new one that better suits their needs, without triggering an immediate taxable event. Which of the following transactions is PERMITTED as a tax-free Section 1035 exchange?

Accepted Answer

A life insurance policy for a qualified long-term care policy.

Answer

An annuity contract for a life insurance policy.

Answer

A life insurance policy for shares of a mutual fund.

Answer

A qualified annuity for a non-qualified annuity.

Question 5

An individual purchased a universal life insurance policy 15 years ago and paid total premiums of $85,000. The policy's cash surrender value is now $115,000. If the individual surrenders the policy for its full cash value, what is the amount of taxable income that must be reported?

Accepted Answer

$30,000

Answer

$115,000

Answer

$85,000

Answer

$0

Question 6

A 45-year-old executive is provided with $200,000 of group term life insurance by her employer. The employer pays the entire premium for this non-discriminatory plan. Based on IRC Section 79, what are the income tax consequences for the executive?

Accepted Answer

The executive must include the economic value (imputed income) of $150,000 of coverage in her gross income.

Answer

The entire premium paid by the employer is considered tax-free compensation.

Answer

The premium for the first $100,000 is tax-free; the premium for the excess is taxable.

Answer

The entire premium is taxable income to the executive.