Question 1

A named beneficiary receives a $250,000 lump-sum death benefit from an individual life insurance policy after the insured's death. How is this benefit generally treated for federal income tax purposes?

Accepted Answer

As a general rule, life insurance death benefits paid in a lump sum to a named beneficiary are received free of federal income tax under IRC Section 101(a).

Question 2

How is the annual growth of cash value inside a permanent life insurance policy treated for federal income tax while the policy remains in force?

Accepted Answer

Cash value accumulates on a tax-deferred basis; this inside buildup is not taxed as it grows as long as the policy stays in force.

Question 3

A policyowner takes a $10,000 loan against the cash value of his non-MEC whole life policy, which remains in force. What is the income tax consequence of the loan?

Accepted Answer

Policy loans from a non-MEC life policy are treated as debt, not income, so they are generally not taxable as long as the policy remains in force.

Question 4

A policyowner surrenders her whole life policy for its $60,000 cash value. She had paid $45,000 in total premiums. How is the surrender taxed?

Accepted Answer

On surrender, the amount received above the cost basis (total premiums paid) is a taxable gain, and it is taxed as ordinary income, not capital gain.

Question 5

A life insurance policy has been classified as a Modified Endowment Contract (MEC). How are distributions such as loans and withdrawals from this policy taxed?

Accepted Answer

MEC distributions are taxed on a LIFO (last-in, first-out) basis, meaning taxable interest/gain comes out first and is subject to income tax.

Question 6

A 45-year-old owner takes a $5,000 loan from his MEC, which includes $2,000 of taxable gain. Beyond ordinary income tax on the gain, what additional consequence typically applies?

Accepted Answer

Because the owner is under age 59½, the taxable portion of a MEC distribution is generally subject to an additional 10% penalty tax, similar to premature annuity distributions.

Question 7

Which of the following exchanges qualifies as a tax-free 1035 exchange?

Accepted Answer

Section 1035 permits tax-free exchanges of a life policy for an annuity, but not the reverse; an annuity may not be exchanged for life insurance without triggering tax.

Question 8

A retiree begins receiving payments from an immediate annuity he purchased with after-tax dollars. What does the exclusion ratio determine?

Accepted Answer

The exclusion ratio identifies the part of each annuity payment that is a tax-free return of the owner's cost basis; the remaining portion is taxable interest.

Question 9

A 50-year-old owner takes a partial withdrawal from her deferred annuity that has grown well above her contributions. How are the withdrawn funds taxed?

Accepted Answer

Withdrawals from a deferred annuity are taxed LIFO, so gain (interest) comes out first as ordinary income; because she is under 59½, a 10% early-withdrawal penalty also applies.

Question 10

An investor purchases an existing life insurance policy on another person for valuable consideration. Under the transfer-for-value rule, what is the general tax result at the insured's death?

Accepted Answer

The transfer-for-value rule causes the death benefit above the buyer's consideration paid plus subsequent premiums to be taxed as ordinary income, unless an exception applies.

Question 11

An insured individual owns a $500,000 policy on her own life and names her son as beneficiary. What is the estate tax consequence at her death?

Accepted Answer

When the insured owns the policy (holds incidents of ownership) at death, the full death benefit is included in her gross estate for federal estate tax purposes, even though it is income-tax-free to the beneficiary.

Question 12

A policyowner receives annual dividends on a participating whole life policy. How are these dividends generally treated for federal income tax?

Accepted Answer

Policy dividends are treated as a return of overpaid premium and are generally not taxable; only interest earned if dividends are left to accumulate becomes taxable.

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