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

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?

Accepted Answer

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

Answer

Withdrawals from non-qualified annuities are taxed on a last-in, first-out (LIFO) basis, meaning the gain is withdrawn first.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?

Accepted Answer

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

Answer

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?

Accepted Answer

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

Answer

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?

Accepted Answer

$30,000

Answer

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).

CLU - Chartered Life Underwriter Practice Test

CLU - Chartered Life Underwriter Practice Test

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