LLQP Taxation of Insurance Products 4 — Questions and Answers
Question 1: A business owns a key person life insurance policy on its CEO. When the CEO dies and the business receives the death benefit, how is this amount treated for federal income tax purposes?
- Fully taxable as ordinary income
- Partially taxable up to the cash surrender value
- Received income tax-free under IRC Section 101(a) (Correct answer)
- Subject to capital gains tax on any gain over premiums paid
Correct answer: Received income tax-free under IRC Section 101(a)
Death benefits paid to a business as beneficiary of a key person life insurance policy are generally received income tax-free under IRC Section 101(a), the same as personal policies.
Question 2: Under the 'transfer for value' rule, which of the following transfers of a life insurance policy would be an EXCEPTION and still allow the death benefit to be received income tax-free?
- A transfer to a business partner of the insured (Correct answer)
- A transfer to the insured's employer
- A transfer to a creditor of the insured
- A transfer to a friend of the insured
Correct answer: A transfer to a business partner of the insured
Transfers to the insured, the insured's partner, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer are exceptions to the transfer for value rule.
Question 3: A traditional IRA owner who is age 72 fails to take the required minimum distribution (RMD) for the year. What is the federal penalty tax on the amount that should have been distributed?
- 10%
- 25% (Correct answer)
- 50%
- 75%
Correct answer: 25%
The SECURE 2.0 Act reduced the penalty for failing to take an RMD from 50% to 25%, and further to 10% if corrected within a correction window.
Question 4: A variable annuity owner exchanges her contract for a new variable annuity contract with a different insurer. Under IRC Section 1035, what is the tax consequence of this exchange?
- The exchange is fully taxable as a surrender of the original contract
- The exchange is tax-free if properly executed as a direct transfer (Correct answer)
- The exchange triggers ordinary income tax on all gains
- The exchange is subject to a 10% penalty if the owner is under age 59½
Correct answer: The exchange is tax-free if properly executed as a direct transfer
A Section 1035 exchange allows the tax-free transfer of one annuity contract for another, provided the exchange is executed as a direct transfer between insurers.
Question 5: Which of the following best describes how employer-paid group term life insurance premiums are treated for an employee whose coverage exceeds $50,000?
- All premiums are included in the employee's gross income
- Only premiums for coverage above $50,000 are included in gross income as imputed income (Correct answer)
- Premiums are never included in gross income regardless of coverage amount
- The entire death benefit is included in the employee's gross income
Correct answer: Only premiums for coverage above $50,000 are included in gross income as imputed income
Employees must include in gross income the cost of group term life insurance coverage exceeding $50,000 as calculated using IRS Table I rates.
Question 6: A life insurance policy is classified as a Modified Endowment Contract (MEC). The policyowner, age 45, takes a policy loan. How is this loan treated for tax purposes?
- Tax-free, since policy loans are never taxable
- Taxable as ordinary income to the extent of gain, and subject to a 10% penalty (Correct answer)
- Taxable only if the loan exceeds the cost basis
- Subject to capital gains tax on the amount borrowed
Correct answer: Taxable as ordinary income to the extent of gain, and subject to a 10% penalty
Loans from a MEC are treated as distributions and are taxable as ordinary income to the extent of gain, plus subject to a 10% penalty if the owner is under age 59½.
Question 7: A Roth IRA owner, age 62, has held the account for 8 years and wants to make a qualified distribution. Which statement is correct?
- The distribution is fully taxable as ordinary income
- The distribution is tax-free since it meets both the age and 5-year holding requirements (Correct answer)
- Only the contributions can be withdrawn tax-free; earnings are taxable
- The distribution is subject to a 10% early withdrawal penalty
Correct answer: The distribution is tax-free since it meets both the age and 5-year holding requirements
A qualified Roth IRA distribution is tax-free if the owner is at least age 59½ and the account has been held for at least 5 years.
LLQP Taxation of Insurance Products 4
A business owns a key person life insurance policy on its CEO.
When the CEO dies and the business receives the death benefit, how is this amount treated for federal income tax purposes?