Recap of Chapter Seven

Premiums paid for personally owned life insurance policies are not tax-deductible for income tax purposes. (7.1)
In a cash value life insurance policy, any growth in the policy's cash value accumulates on a tax-deferred basis. Income tax is generally not owed on these gains until the policyowner withdraws funds from the policy. (7.1)
If a partial or full surrender of a cash value policy occurs, any amount received that exceeds the total premiums paid (the policy's cost basis) is taxable as ordinary income in the year the distribution is made. (7.1)
Policy loans taken against the cash value of a life insurance policy are generally not taxable at the time the loan is received, because the funds are treated as a loan rather than income. (7.1)
Any interest paid to the insurer on a policy loan is not tax-deductible for the policyowner. (7.1)
A participating cash value policy may pay policy dividends to policyowners. These dividends represent a distribution of the insurer's surplus earnings for the year and are typically considered a return of premium rather than taxable income, unless they exceed the total premiums paid. (7.1)
Dividends paid by a life insurance company are generally considered by the Internal Revenue Service (IRS) to be a refund of excess premiums rather than profit or income to the policyowner. As a result, these dividends are generally not taxable. (7.1)
If policy dividends are left with the insurer under the accumulation at interest option, the interest credited on those accumulated dividends is taxable as ordinary income in the year it is earned. (7.1)
Under the paid-up additions dividend option, dividends are used to purchase additional fully paid life insurance coverage. These additional amounts increase both the death benefit and the policy's cash value and are issued without requiring evidence of insurability. (7.1)
In most cases, life insurance death benefit proceeds paid to a beneficiary are received income tax-free. However, if the insurer holds the proceeds for a period of time after the insured's death and interest accumulates before payment, that interest portion is taxable as income to the beneficiary. (7.1)
If a beneficiary chooses to receive the proceeds through a settlement option rather than a lump sum, each payment typically consists of principal (the death benefit) and interest. The principal portion remains income tax-free, while the interest portion is taxable. (7.1)
An Accelerated Death Benefit (ADB) is a rider or policy provision that allows the policyowner to access a portion of the death benefit while the insured is still living, typically when the insured has been diagnosed with a terminal illness. (7.1)
To be considered terminally ill, the insured must be diagnosed by a physician as having a life expectancy of 24 months or less. (7.1)
Accelerated Death Benefits (ADB) are treated as an advance payment of the policy's death benefit. To qualify for this benefit, certain conditions specified in the policy and applicable regulations must be met. (7.1)
The death benefit of a life insurance policy may be included in the taxable estate of the deceased insured if the insured retained any incidents of ownership in the policy at the time of death, such as the ability to change beneficiaries or borrow against the policy. (7.1)
Premiums paid by an employer for group life insurance coverage provided as an employee benefit are generally tax-deductible to the business. When the amount of coverage provided to an employee does not exceed $50,000, the employee does not incur income tax liability, even if the employer pays the entire premium. (7.2)
If the group life insurance benefit exceeds $50,000, the portion of the premium paid by the employer for coverage above $50,000 must be reported as taxable income to the employee. This reporting ensures that the death benefit received by the beneficiary remains income tax-free. (7.2)
A Modified Endowment Contract (MEC) is a type of cash value life insurance policy that has accumulated excess cash value during the first seven years of the policy, typically as a result of premium payments exceeding the limits established under federal tax law. (7.3)
The 7-Pay Test is the standard used to determine whether a life insurance policy is classified as a Modified Endowment Contract (MEC). This test compares the premiums paid during the first seven years of the policy to the maximum amount that could be paid to fully fund the policy within that same period. Certain policy changes—such as increasing or decreasing the death benefit or exchanging the policy for another life insurance contract—may cause the seven-year testing period to restart. (7.3)
Under MEC tax rules, distributions taken from the policy before the policyowner reaches age 59½ may be subject to a 10% early withdrawal penalty, in addition to ordinary income tax on any taxable portion of the distribution. Exceptions to the penalty may apply in cases involving the death or total disability of the insured. (7.3)
Single premium whole life policies are automatically classified as Modified Endowment Contracts, because the policy is funded with a large premium at the outset. Universal life policies are also more likely to become MECs if they are overfunded with excess premiums. In contrast, a traditional ordinary whole life policy typically does not become a MEC because its premium structure generally prevents excessive funding. (7.3)
Ownership of a life insurance policy may be transferred to another individual or entity at any time before the insured's death. However, for the death benefit to remain income tax-free to the beneficiary, the transfer must meet certain exceptions to the transfer-for-value rule. (7.4)
Under Internal Revenue Code (IRC) Section 1035, policyowners may exchange certain life insurance, endowment, or annuity contracts for another qualifying contract without triggering immediate income tax on the policy's accumulated cash value. This provision allows policyholders to replace or upgrade policies while preserving the tax-deferred status of the funds. (7.5)
Permissible exchanges under Internal Revenue Code (IRC) Section 1035 include life insurance to life insurance, life insurance to an annuity, and annuity to annuity exchanges. However, an annuity contract cannot be exchanged for a life insurance policy under Section 1035. (7.5)
Distributions from nonqualified annuities are generally taxable only on the earnings or gain portion of the distribution. The return of the original premium (the cost basis) is not subject to income tax. (7.6)
If annuity benefits are paid to a beneficiary upon the death of the annuitant, any portion of the payment that represents accumulated gains in the contract is taxable as income to the beneficiary. (7.6)
When annuity payments terminate completely upon the death of the annuitant, there is generally no estate tax liability associated with the annuity payments. However, any remaining amounts that are payable to a beneficiary may be included in the policyowner's estate for estate tax purposes. (7.6)
An IRA rollover occurs when funds from an Individual Retirement Account (IRA) or another qualified retirement plan are distributed to the account holder and then re-deposited into another IRA within 60 days of the distribution. (7.8)
Only one IRA-to-IRA rollover is permitted within a 12-month period, regardless of the amount involved. However, there is no limit on the dollar amount that may be rolled over, and there is no restriction on the number of direct rollovers (trustee-to-trustee transfers) from employer-sponsored qualified plans to an IRA. (7.8)
A direct transfer between IRAs occurs when assets are moved directly from one custodian to another custodian without being distributed to the account owner. Because the funds are transferred directly between institutions, the account owner does not receive the funds and no taxable distribution occurs. There is no limit on the number of direct IRA transfers that may be completed in a year, and there is no restriction on the dollar amount that may be transferred. (7.8)