Life & Health Insurance Exam Premium Calculations and Tax Treatment 2 — Questions and Answers
Question 1: Cash value withdrawals from a whole life policy are taxed as:
- Ordinary income on the full amount withdrawn
- Ordinary income only to the extent they exceed the policy's cost basis (Correct answer)
- Capital gains on the full amount withdrawn
- Tax-free regardless of the amount
Correct answer: Ordinary income only to the extent they exceed the policy's cost basis
Life insurance cash value withdrawals are tax-free up to the policy's cost basis (total premiums paid); amounts above the basis are taxable as ordinary income.
Question 2: What is the 'mortality and expense risk charge' (M&E) in a variable annuity?
- A one-time charge deducted when the annuity is purchased
- An annual fee charged by the insurer for insurance guarantees and administrative costs (Correct answer)
- A penalty for early surrender of the annuity
- A tax imposed by the IRS on annuity earnings
Correct answer: An annual fee charged by the insurer for insurance guarantees and administrative costs
The M&E charge is an ongoing annual fee deducted from the annuity's account value to compensate the insurer for mortality risk and administrative expenses.
Question 3: Dividends paid on a participating whole life policy are considered by the IRS as:
- Taxable dividends, similar to stock dividends
- A return of premium and generally not taxable until they exceed premiums paid (Correct answer)
- Ordinary income in the year received
- Capital gains in the year received
Correct answer: A return of premium and generally not taxable until they exceed premiums paid
Policy dividends are treated as a return of the premium (cost basis) and are not taxable income unless they exceed the total premiums paid.
Question 4: Which of the following best describes 'experience rating' in group health insurance?
- Rating based solely on each individual member's health history
- Adjusting group premiums based on the group's own claims history (Correct answer)
- Using industry-wide statistics to set a flat premium for all groups
- Setting premiums based on the geographic location of the group
Correct answer: Adjusting group premiums based on the group's own claims history
Experience rating sets a group's premium based primarily on that group's own past claims experience, rewarding healthy groups with lower rates.
Question 5: Under the modified endowment contract (MEC) rules, policy loans from a MEC are taxed as:
- Always tax-free like regular policy loans
- Ordinary income to the extent of gain, plus a 10% penalty if under age 59½ (Correct answer)
- Capital gains only if the policy is surrendered
- Taxable only if the policy lapses
Correct answer: Ordinary income to the extent of gain, plus a 10% penalty if under age 59½
Loans and withdrawals from a MEC are subject to LIFO taxation (gain out first) and an additional 10% penalty tax if taken before age 59½.
Question 6: A self-employed individual can deduct health insurance premiums paid for themselves and their family as:
- A business expense on Schedule C
- An above-the-line deduction on Schedule 1 of Form 1040 (Correct answer)
- An itemized deduction on Schedule A only
- No deduction is allowed for self-employed individuals
Correct answer: An above-the-line deduction on Schedule 1 of Form 1040
Self-employed individuals may deduct 100% of health insurance premiums as an above-the-line adjustment to income on Form 1040, Schedule 1.
Life & Health Insurance Exam Premium Calculations and Tax Treatment 2
Cash value withdrawals from a whole life policy are taxed as: