Federal Tax Considerations for Life Insurance and Annuities

Vocabulary flashcards covering MECs, 1035 exchanges, IRAs, Roth vs traditional IRAs, penalties, and related taxation concepts from the notes.

Death benefits (life insurance)

Tax-free to beneficiaries; generally not subject to income tax when paid on death.

Dividends — mutual insurance companies

Not taxable to policyowner because they are considered a return of premium.

Dividends — stock life insurance

Taxable as ordinary income to the owner; not taxed as capital gains.

Cash surrender gain

Amount received that exceeds premiums paid is a taxable event.

1035 exchange

Tax-deferred transfer of value to a new contract; used when surrendering one policy to buy another; taxes are deferred, not avoided.

Group life insurance benefits

Not taxable to the beneficiary upon the employee's death.

Premiums for individual and key person life insurance

Not tax-deductible; benefits are not taxed.

Charitable gift of life policy

Policyowner may receive a tax deduction in the year of the gift.

Modified Endowment Contracts (MECs)

Lose favored tax treatment as life insurance; IRS treats them as investments; classified as life insurance for the life of the contract.

7-pay test

A test used to determine MEC status; if failed, loans and withdrawals may become taxable.

Material change to a cash value policy

Can trigger reapplication of the 7-pay test and potentially classify the policy as a MEC.

MEC tax penalties

MECs have a 10% IRS penalty for premature distributions.

IRAs funded with annuities

IRAs may be funded with annuities but not with whole life policies.

Deferred annuities funding an IRA

Deferred annuities may be used to fund an IRA.

Traditional IRA contributions (deductibility)

Deductible if the individual and spouse aren’t covered by a workplace retirement plan.

Direct transfer of IRA funds

A direct trustee-to-trustee transfer is not taxable.

Qualified retirement plans (tax advantages)

Contributions are deductible to employers; taxes are deferred to distribution for employees.

Early withdrawal penalties (59½ rule)

10% penalty on cash surrenders on annuities, IRAs, TSAs, and Keogh plans before age 59½ unless death or disability occurs (plus income tax).

First-time homebuyer exception

Premature IRA distributions may be taken without the 10% penalty, up to a lifetime limit, for a first-time home purchase.

Education expenses exception

Premature distributions for qualified educational expenses from a deductible IRA are penalty-free but still subject to income tax.

Bankruptcy and penalties

Penalty exemptions are not waived by bankruptcy.

Roth IRA features

No required distribution date; qualified distributions are tax-free if the account is held at least 5 years and the owner is at least 59½.

Roth IRA vs Traditional IRA (deduction/distribution)

Roth: no RMD during owner’s life; distributions after 5-year rule and 59½ are tax-free; Traditional: contributions may be deductible if not covered by workplace plan; distributions later are taxable.

5-year Roth rule

Five-year holding period for tax-free Roth distributions.

Section 1035 exchanges (annuity to annuity)

Under 1035, an annuity may be exchanged for another annuity; not for life insurance (per notes).

Taxes and 1035 exchanges

Exchanges defer taxes but do not avoid them.