Tax treatment of life insurance and annuities, including modified endowment contracts

Question 1

For federal income-tax purposes, what does a contract's adjusted basis generally represent?

Accepted Answer

After-tax investment that has not yet been recovered

Answer

The current cash value, including accumulated earnings

Answer

The death benefit remaining after policy loans

Answer

The earnings available for a taxable withdrawal

Question 2

An individual pays premiums for personal life insurance benefiting her family. How are these premiums generally treated on her federal income-tax return?

Accepted Answer

They are paid with after-tax dollars and are not deductible.

Answer

They are deductible because the policy provides a death benefit.

Answer

They are deductible to the extent they increase cash value.

Answer

They become deductible when the insured reaches age 59½.

Question 3

A beneficiary receives $200,000 of ordinary life insurance death proceeds plus $4,000 of interest earned while the insurer held those proceeds. What amount is generally subject to federal income tax?

Accepted Answer

$4,000

Answer

$0

Answer

$200,000

Answer

$204,000

Question 4

A non-MEC life policy has $30,000 of adjusted basis and $42,000 of cash value. Its owner takes an ordinary $8,000 partial withdrawal subject to basis-first treatment. How much of the withdrawal is currently taxable?

Accepted Answer

$0

Answer

$8,000

Answer

$12,000

Answer

$2,286, approximately

Question 5

An owner fully surrenders a life policy for $54,000. Its adjusted basis is $40,000, and there are no outstanding loans. What is the general federal income-tax result?

Accepted Answer

$14,000 of ordinary income

Answer

$54,000 of ordinary income

Answer

$14,000 of long-term capital gain

Answer

No taxable income because the policy insured a life

Question 6

What does the federal seven-pay test primarily compare when determining whether a newly issued life policy is a MEC?

Accepted Answer

Cumulative premiums paid with cumulative permitted seven-pay premiums

Answer

Cash value with premiums paid during the most recent seven years

Answer

Annual death benefits with annual cash-value increases

Answer

The owner's age with seven years remaining until retirement

Question 7

At a point in the third contract year, a new policy's applicable cumulative seven-pay limit is $18,000. A premium brings cumulative payments to $19,000 and remains in the contract. Which conclusion follows?

Accepted Answer

The policy fails because cumulative payments exceed the applicable limit.

Answer

The policy passes because fewer than seven years have elapsed.

Answer

The policy passes if its cash value is below $18,000.

Answer

The policy fails only if the third-year premium alone exceeds $18,000.

Question 8

Which statement correctly distinguishes a MEC from a contract that fails the federal definition of life insurance?

Accepted Answer

A MEC meets section 7702 but has the distribution status specified by section 7702A.

Answer

A MEC fails section 7702 but passes the seven-pay test.

Answer

A MEC is a nonqualified annuity because it no longer qualifies as life insurance.

Answer

A MEC fails federal qualification whenever its owner takes a loan.

Question 9

Which federal income-tax treatment generally applies to a withdrawal from a MEC that contains gain?

Accepted Answer

Earnings are distributed before basis.

Answer

Basis is recovered before earnings.

Answer

Each withdrawal is allocated proportionally between basis and earnings.

Answer

Earnings remain excluded if the policy stays in force.

Question 10

A MEC has $50,000 of basis and $62,000 of cash value. The owner withdraws $15,000. Ignoring any additional tax, how much is generally ordinary income?

Accepted Answer

$12,000

Answer

$15,000

Answer

$3,000

Answer

$0

Question 11

An owner has a MEC and proposes borrowing against it instead of withdrawing cash to avoid distributing gain. Which response best evaluates that plan?

Accepted Answer

A MEC loan generally receives earnings-first distribution treatment, so borrowing does not by itself avoid taxable gain.

Answer

A MEC loan is generally tax free until the owner's basis has been withdrawn.

Answer

A MEC loan converts earnings to basis because it must be repaid.

Answer

A MEC loan receives the annuity exclusion ratio instead of withdrawal ordering.

Question 12

A 45-year-old receives a $10,000 MEC distribution, of which $6,000 is taxable income. No exception applies. What is the additional federal tax under the MEC premature-distribution rule?

Accepted Answer

$600

Answer

$1,000

Answer

$400

Answer

$0

Question 13

A 62-year-old takes a MEC withdrawal consisting entirely of earnings. What effect does the owner's age have on its federal tax treatment?

Accepted Answer

The age exception removes the ten-percent additional tax, while the earnings remain ordinary income.

Answer

Both ordinary income tax and the ten-percent additional tax are eliminated.

Answer

Ordinary income tax is eliminated, but the ten-percent additional tax remains.

Answer

The earnings become capital gain because the owner is past age 59½.

Question 14

Which circumstance is an express exception to the ten-percent additional federal tax on a taxable MEC distribution before age 59½?

Accepted Answer

The distribution is attributable to the taxpayer's qualifying disability.

Answer

The policy has been in force for seven years.

Answer

The owner uses the proceeds to pay personal life insurance premiums.

Answer

The insurer labels the payment a policy loan.

Question 15

An owner exchanges a MEC for a newly issued life insurance contract. The replacement otherwise meets section 7702. How does section 7702A treat the replacement?

Accepted Answer

It is a MEC because it was received in exchange for a MEC.

Answer

It becomes a non-MEC because the insurer issues a new policy number.

Answer

It becomes a non-MEC if no new cash premium is paid.

Answer

It becomes a non-MEC when the original policy is more than seven years old.

Question 16

A client says, 'If my policy becomes a MEC, my family's ordinary death benefit loses its federal income-tax exclusion.' What is the best correction?

Accepted Answer

MEC status changes distribution taxation during life but does not itself remove the usual death-benefit exclusion.

Answer

The benefit becomes taxable to the extent it exceeds premiums paid.

Answer

The benefit is excluded only if the insured dies after age 59½.

Answer

The benefit is allocated between basis and income using an annuity exclusion ratio.

Question 17

What is the exclusion ratio for annuitized payments under the general federal rule?

Accepted Answer

Investment in the contract divided by expected return

Answer

Expected return divided by investment in the contract

Answer

Accumulated earnings divided by premiums paid

Answer

The current payment divided by cash surrender value

Question 18

A fixed nonqualified annuity has $72,000 of investment and an expected return of $120,000 at annuitization. Before basis is exhausted, how much of each $1,500 payment is excluded from gross income?

Accepted Answer

$900

Answer

$600

Answer

$1,500

Answer

$1,080

Question 19

An annuitant has recovered the entire investment in a nonqualified annuity through prior exclusions. Under the general rule, how are later annuity payments taxed?

Accepted Answer

The payments are fully taxable because no unrecovered investment remains.

Answer

The original exclusion ratio continues to exclude the same percentage.

Answer

The payments become fully excluded because the investment has been repaid.

Answer

Half of each payment is excluded as a new recovery allowance.

Question 20

An annuity's usual exclusion is $600 per payment. Immediately before the next $1,000 payment, only $250 of unrecovered investment remains. How much of this payment is taxable?

Accepted Answer

$750

Answer

$400

Answer

$250

Answer

$1,000

Question 21

Before annuitization, an individually owned nonqualified annuity has $80,000 of basis and $95,000 of value. The owner withdraws $10,000. How much is generally included in income?

Accepted Answer

$10,000

Answer

$0

Answer

$1,579, approximately

Answer

$15,000

Question 22

A client asks why a withdrawal before annuitization may be fully taxable while a later annuitized payment is partly excluded. Which explanation is best?

Accepted Answer

The two payment types use different allocation rules: earnings first for withdrawals and an exclusion ratio for annuitized payments.

Answer

Annuitization converts previously untaxed earnings into after-tax basis.

Answer

The age threshold converts every payment after annuitization into tax-free income.

Answer

The first annuitized payment returns the entire investment before any earnings are paid.

Question 23

A qualified annuity was funded entirely with pretax contributions and has no after-tax basis. How are its distributions generally treated for federal income tax?

Accepted Answer

They are fully taxable.

Answer

The contribution portion is excluded and earnings are taxable.

Answer

They are fully excluded once the owner reaches age 59½.

Answer

Half of each distribution is excluded under the exclusion ratio.

Question 24

A 50-year-old receives $9,000 from a nonqualified annuity; $4,000 is included in gross income. No exception to the premature-distribution rule applies. What is the additional federal tax?

Accepted Answer

$400

Answer

$900

Answer

$500

Answer

$0

Question 25

In year 12, a life policy undergoes a material change within section 7702A(c)(3) that was not reflected in a previous determination. What is required for seven-pay testing?

Accepted Answer

The policy is treated as new on the change date, with appropriate cash-surrender-value adjustments.

Answer

No new test is needed because the original seven-year period ended.

Answer

The policy is treated as new beginning with its original issue date.

Answer

The policy is treated as new without considering existing cash surrender value.

Question 26

An owner voluntarily reduces a policy's benefits in its fourth contract year. The reduction is not caused by nonpayment. Why can this affect the seven-pay test?

Accepted Answer

The test is generally reapplied as though the policy had originally been issued at the reduced benefit level.

Answer

The reduction changes earlier premiums into taxable distributions.

Answer

The reduction makes prior premium amounts irrelevant to the test.

Answer

The reduction postpones the initial testing period until the eighth contract year.

Question 27

Two policies have the same stated seven-pay limits: $5,000 cumulatively in year one and $10,000 in year two. Policy P receives $6,000 in year one and no more in year two. Policy Q receives $5,000 in each year. No correction or policy change occurs. Which comparison is correct?

Accepted Answer

P fails at the year-one excess; Q does not exceed either stated limit.

Answer

Both pass because neither has more than $10,000 paid by year two.

Answer

Q fails because paying the full annual limit is excessive funding.

Answer

Both must remain unclassified until the end of year seven.

Question 28

A non-MEC policyowner says, 'My policy loan was not taxable when I took it, so a later lapse cannot create taxable income.' Which response best identifies the flaw?

Accepted Answer

A lapse with outstanding debt can produce taxable gain even if the original loan produced no current income.

Answer

The original loan must have been taxable merely because the owner borrowed.

Answer

A lapse makes the policy's full death benefit taxable to the owner.

Answer

A lapse changes policy gain into a deductible personal loss.

Question 29

A participating life policy pays a $700 dividend that is a return of premium within the owner's remaining basis. The insurer also pays $40 of interest on dividends previously retained. What is generally current taxable income?

Accepted Answer

$40

Answer

$740

Answer

$700

Answer

$0

Question 30

What does tax-deferred cash-value growth in a qualifying life insurance policy generally mean?

Accepted Answer

Internal growth generally is not taxed annually merely as it accumulates.

Answer

Cash-value growth is taxed annually but collected at surrender.

Answer

Internal growth is excluded from income under every later distribution method.

Answer

The owner deducts premiums and reports annual cash-value growth.

Question 31

Which funding description generally fits an individually owned nonqualified annuity purchased outside a retirement plan?

Accepted Answer

After-tax investment with tax-deferred internal earnings

Answer

Deductible investment with permanently excluded distributions

Answer

Pretax investment with tax-free recovery of all contributions

Answer

After-tax investment with annual taxation of undistributed internal earnings

Question 32

A 52-year-old receives taxable MEC distributions under a qualifying series of substantially equal annual payments for her life expectancy. What does this qualifying arrangement do under section 72(v)?

Accepted Answer

It provides an exception to the ten-percent additional tax.

Answer

It makes the taxable portion a return of basis.

Answer

It restores non-MEC status to the contract.

Answer

It delays recognition of the payments until age 59½.

Question 33

A 60-year-old says that taking a taxable nonqualified annuity withdrawal without the age-related additional tax means the withdrawal is tax free. Which distinction corrects the statement?

Accepted Answer

Age can remove the additional tax while the taxable withdrawal remains included in income.

Answer

The ten-percent tax replaces ordinary income tax after age 59½.

Answer

Age removes ordinary income tax but leaves the additional tax in place.

Answer

Age changes distributed annuity earnings to long-term capital gain.

Question 34

A policyowner has paid $25,000 in personal life premiums and received $2,000 in dividends treated entirely as returns of premium. There are no other basis adjustments. What is the adjusted basis?

Accepted Answer

$23,000

Answer

$25,000

Answer

$27,000

Answer

$2,000

Question 35

An ordinary non-MEC life policy and a MEC each have $20,000 of basis and $28,000 of value. Each owner takes a $5,000 withdrawal; the non-MEC withdrawal qualifies for basis-first treatment. Ignoring additional taxes, how do the taxable amounts compare?

Accepted Answer

The non-MEC produces $0 of taxable income; the MEC produces $5,000.

Answer

Both withdrawals produce $0 of taxable income.

Answer

Both withdrawals produce $5,000 of taxable income.

Answer

The non-MEC produces $5,000 of taxable income; the MEC produces $0.

Question 36

A producer tells a beneficiary, 'These death proceeds are excluded from federal income tax, so they cannot be relevant to estate taxation.' What is the best evaluation?

Accepted Answer

Incorrect; income-tax exclusion and estate-tax treatment are separate questions.

Answer

Correct; income-tax exclusion determines estate-tax exclusion.

Answer

Incorrect; estate-tax relevance makes the entire benefit ordinary income.

Answer

Correct if the insured was older than 59½ at death.

Question 37

Which statement accurately explains what the seven-pay test requires of a policyowner's premium schedule?

Accepted Answer

The test establishes a cumulative funding limit rather than requiring seven actual annual premium payments.

Answer

The owner must pay a premium in each of seven consecutive years.

Answer

The owner must stop paying premiums after the seventh contract year.

Answer

The owner must pay equal premiums even when cumulative payments remain below the permitted limits.

Question 38

An owner borrows $5,000 against an ordinary non-MEC life policy, and the policy remains in force. What is the general immediate federal income-tax treatment of the loan?

Accepted Answer

The loan generally creates no current income.

Answer

The loan is taxable to the extent of accumulated gain under MEC rules.

Answer

The loan is allocated between taxable income and basis by an exclusion ratio.

Answer

The loan is fully taxable because the insurer disbursed cash.

Question 39

Two retirees receive annuity payments. One annuity was funded entirely with pretax money; the other has unrecovered after-tax investment. Why should the producer not assume the same excluded percentage for both?

Accepted Answer

The pretax-funded contract has no after-tax basis to recover, while the other contract does.

Answer

Qualified annuities receive a larger exclusion because contributions were deductible.

Answer

The same age threshold assigns different capital-gain rates to the two contracts.

Answer

Nonqualified annuity payments exclude earnings before recovering investment.

Question 40

A fixed nonqualified annuity has $45,000 of investment and $75,000 of expected return at annuitization. Its owner receives $10,000 in annuitized payments during the year, with ample unrecovered basis. What amount is included in gross income?

Accepted Answer

$4,000

Answer

$6,000

Answer

$10,000

Answer

$0

For federal income-tax purposes, what does a contract's adjusted basis generally represent?

An individual pays premiums for personal life insurance benefiting her family. How are these premiums generally treated on her federal income-tax return?

A beneficiary receives $200,000 of ordinary life insurance death proceeds plus $4,000 of interest earned while the insurer held those proceeds. What amount is generally subject to federal income tax?

A non-MEC life policy has $30,000 of adjusted basis and $42,000 of cash value. Its owner takes an ordinary $8,000 partial withdrawal subject to basis-first treatment. How much of the withdrawal is currently taxable?

An owner fully surrenders a life policy for $54,000. Its adjusted basis is $40,000, and there are no outstanding loans. What is the general federal income-tax result?

What does the federal seven-pay test primarily compare when determining whether a newly issued life policy is a MEC?

At a point in the third contract year, a new policy's applicable cumulative seven-pay limit is $18,000. A premium brings cumulative payments to $19,000 and remains in the contract. Which conclusion follows?

Which statement correctly distinguishes a MEC from a contract that fails the federal definition of life insurance?

Which federal income-tax treatment generally applies to a withdrawal from a MEC that contains gain?

A MEC has $50,000 of basis and $62,000 of cash value. The owner withdraws $15,000. Ignoring any additional tax, how much is generally ordinary income?

An owner has a MEC and proposes borrowing against it instead of withdrawing cash to avoid distributing gain. Which response best evaluates that plan?

A 45-year-old receives a $10,000 MEC distribution, of which $6,000 is taxable income. No exception applies. What is the additional federal tax under the MEC premature-distribution rule?

A 62-year-old takes a MEC withdrawal consisting entirely of earnings. What effect does the owner's age have on its federal tax treatment?

Which circumstance is an express exception to the ten-percent additional federal tax on a taxable MEC distribution before age 59½?

An owner exchanges a MEC for a newly issued life insurance contract. The replacement otherwise meets section 7702. How does section 7702A treat the replacement?

A client says, 'If my policy becomes a MEC, my family's ordinary death benefit loses its federal income-tax exclusion.' What is the best correction?

What is the exclusion ratio for annuitized payments under the general federal rule?

A fixed nonqualified annuity has $72,000 of investment and an expected return of $120,000 at annuitization. Before basis is exhausted, how much of each $1,500 payment is excluded from gross income?

An annuitant has recovered the entire investment in a nonqualified annuity through prior exclusions. Under the general rule, how are later annuity payments taxed?

An annuity's usual exclusion is $600 per payment. Immediately before the next $1,000 payment, only $250 of unrecovered investment remains. How much of this payment is taxable?

Before annuitization, an individually owned nonqualified annuity has $80,000 of basis and $95,000 of value. The owner withdraws $10,000. How much is generally included in income?

A client asks why a withdrawal before annuitization may be fully taxable while a later annuitized payment is partly excluded. Which explanation is best?

A qualified annuity was funded entirely with pretax contributions and has no after-tax basis. How are its distributions generally treated for federal income tax?

A 50-year-old receives $9,000 from a nonqualified annuity; $4,000 is included in gross income. No exception to the premature-distribution rule applies. What is the additional federal tax?

In year 12, a life policy undergoes a material change within section 7702A(c)(3) that was not reflected in a previous determination. What is required for seven-pay testing?

An owner voluntarily reduces a policy's benefits in its fourth contract year. The reduction is not caused by nonpayment. Why can this affect the seven-pay test?

Two policies have the same stated seven-pay limits: $5,000 cumulatively in year one and $10,000 in year two. Policy P receives $6,000 in year one and no more in year two. Policy Q receives $5,000 in each year. No correction or policy change occurs. Which comparison is correct?

A non-MEC policyowner says, 'My policy loan was not taxable when I took it, so a later lapse cannot create taxable income.' Which response best identifies the flaw?

A participating life policy pays a $700 dividend that is a return of premium within the owner's remaining basis. The insurer also pays $40 of interest on dividends previously retained. What is generally current taxable income?

What does tax-deferred cash-value growth in a qualifying life insurance policy generally mean?

Which funding description generally fits an individually owned nonqualified annuity purchased outside a retirement plan?

A 52-year-old receives taxable MEC distributions under a qualifying series of substantially equal annual payments for her life expectancy. What does this qualifying arrangement do under section 72(v)?

A 60-year-old says that taking a taxable nonqualified annuity withdrawal without the age-related additional tax means the withdrawal is tax free. Which distinction corrects the statement?

A policyowner has paid $25,000 in personal life premiums and received $2,000 in dividends treated entirely as returns of premium. There are no other basis adjustments. What is the adjusted basis?

An ordinary non-MEC life policy and a MEC each have $20,000 of basis and $28,000 of value. Each owner takes a $5,000 withdrawal; the non-MEC withdrawal qualifies for basis-first treatment. Ignoring additional taxes, how do the taxable amounts compare?

A producer tells a beneficiary, 'These death proceeds are excluded from federal income tax, so they cannot be relevant to estate taxation.' What is the best evaluation?

Which statement accurately explains what the seven-pay test requires of a policyowner's premium schedule?

An owner borrows $5,000 against an ordinary non-MEC life policy, and the policy remains in force. What is the general immediate federal income-tax treatment of the loan?

Two retirees receive annuity payments. One annuity was funded entirely with pretax money; the other has unrecovered after-tax investment. Why should the producer not assume the same excluded percentage for both?

A fixed nonqualified annuity has $45,000 of investment and $75,000 of expected return at annuitization. Its owner receives $10,000 in annuitized payments during the year, with ample unrecovered basis. What amount is included in gross income?

Ready when you are