Free Chartered Life Underwriter (CLU) Income Taxation Principles Questions and Answers — 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?
- The loan is treated as a distribution; $40,000 is taxable as ordinary income. (Correct answer)
- The entire $50,000 loan is treated as a tax-free return of premium.
- The loan is treated as a distribution; $50,000 is taxable as a long-term capital gain.
- The loan is not a taxable event because it is secured by the policy's cash value.
Correct answer: The loan is treated as a distribution; $40,000 is taxable as ordinary income.
Under IRC Section 7702A, distributions from a Modified Endowment Contract (MEC), including policy loans, are taxed on a last-in, first-out (LIFO) basis. This means the taxable gain ($150,000 cash value - $110,000 basis = $40,000) is considered distributed first. Therefore, the first $40,000 of the $50,000 loan is taxable as ordinary income.
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?
- The $20,000 withdrawal is subject to a 10% penalty, but not ordinary income tax.
- The entire $20,000 is taxed as ordinary income, plus a 10% penalty on the $20,000. (Correct answer)
- The withdrawal is a tax-free return of basis.
- $15,000 is a tax-free return of basis, and $5,000 is taxed as ordinary income.
Correct answer: The entire $20,000 is taxed as ordinary income, plus a 10% penalty on the $20,000.
Withdrawals from non-qualified annuities are taxed on a last-in, first-out (LIFO) basis, meaning the gain is withdrawn first. The total gain in the contract is $30,000 ($120,000 value - $90,000 basis). Since the $20,000 withdrawal is less than the total gain, the entire withdrawal is taxable as ordinary income. Additionally, because the owner is under age 59½, a 10% penalty applies to the taxable portion of the distribution.
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?
- Dividends are always taxable as ordinary income in the year they are received.
- Dividends are treated as a tax-free return of premium until they exceed the policy's cost basis. (Correct answer)
- Dividends can only be used to purchase paid-up additions and are never subject to tax.
- Dividends are taxed as long-term capital gains, regardless of the amount paid in premiums.
Correct answer: Dividends are treated as a tax-free return of premium until they exceed the policy's cost basis.
The IRS generally considers dividends from a participating life insurance policy to be a refund or return of a portion of the premiums paid. As such, they are not taxable until the total amount of dividends received exceeds the policyowner's cost basis (total premiums paid). If dividends are left to accumulate interest with the insurer, the interest earned is taxable income.
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?
- An annuity contract for a life insurance policy.
- A life insurance policy for a qualified long-term care policy. (Correct answer)
- A life insurance policy for shares of a mutual fund.
- A qualified annuity for a non-qualified annuity.
Correct answer: A life insurance policy for a qualified long-term care policy.
IRC Section 1035 allows for tax-free exchanges of certain insurance products. Permitted exchanges include a life insurance policy for another life insurance policy, an endowment contract, an annuity, or a qualified long-term care policy. An exchange of an annuity for a life insurance policy is explicitly not permitted on a tax-free basis.
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?
- $115,000
- $85,000
- $30,000 (Correct answer)
- $0
Correct answer: $30,000
When a life insurance policy is surrendered, the amount received that exceeds the policyowner's cost basis is taxable as ordinary income. The cost basis is the total amount of premiums paid into the contract. In this case, the taxable gain is the cash surrender value minus the cost basis ($115,000 - $85,000 = $30,000).
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?
- The entire premium paid by the employer is considered tax-free compensation.
- The premium for the first $100,000 is tax-free; the premium for the excess is taxable.
- The executive must include the economic value (imputed income) of $150,000 of coverage in her gross income. (Correct answer)
- The entire premium is taxable income to the executive.
Correct answer: The executive must include the economic value (imputed income) of $150,000 of coverage in her gross income.
Under IRC Section 79, the cost of the first $50,000 of employer-provided group term life insurance is excluded from an employee's gross income. The economic benefit (cost) of coverage exceeding $50,000 must be included in the employee's taxable income. The amount included is not the actual premium but an amount determined by an IRS table (Uniform Premium Table I). Therefore, the executive has taxable imputed income based on $150,000 of coverage ($200,000 total coverage - $50,000 exclusion).
Free Chartered Life Underwriter (CLU) Income Taxation Principles Questions and Answers
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?