In this chapter we will discuss federal income taxation of life insurance, annuities, and retirement plans.

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1 Chapter Seven FEDERAL TAX CONSIDERATIONS AND RETIREMENT PLANS LEARNING OBJECTIVES Upon the completion of this chapter, you will be able to: 1. Identify taxation of premiums, cash values, policy loans and dividends as it applies to personal life insurance 2. List the characteristics of a Modified Endowment Contract 3. Describe the taxation of group insurance premiums and proceeds 4. Recognize what constitutes a 1035 Exchange 5. Define the exclusion ratio in an annuity 6. Compare a qualified and nonqualified retirement plan 7. Identify ERISA requirements 8. Compare and contrast a Traditional and Roth IRA 9. List the types of qualified retirement plans OVERVIEW In this chapter we will discuss federal income taxation of life insurance, annuities, and retirement plans. 7.1 Taxation of Personal Life Insurance Premiums For individuals, premiums are considered a personal expense and are not deductible. They are paid with after-tax dollars. This establishes a cost basis in the policy for tax purposes. Cash Values A cash value policy will experience increases in the cash value annually. Part is from the premium and part is from any interest or gains. The interest or gains are not taxable at the time they are credited to the policy. Any earnings in the cash value are allowed to grow on a tax-deferred basis until one of the following events occurs: The policy is surrendered The policy is transferred for value (e.g. sold or assigned) The policy ceases to meet the IRS definition of a life insurance contract If the policyowner does sell, surrender, or withdraw funds from the policy, the difference between what is received and what had been paid in is taxed as ordinary income. This is the Cost Recovery Rule. 93

2 LIFE AND HEALTH When withdrawing cash from a cash value life insurance policy, the amount of withdrawals up to the policy s basis will be tax free. This is referred to as First In, First Out, or FIFO. The Cost Basis is the amount of premiums paid into the policy less any dividends or withdrawals previously taken. Any withdrawals in excess of basis will be taxed as ordinary income. Upon surrendering a cash value life insurance policy, any gains will be subject to federal and possibly state income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out, plus any loans outstanding, and the cost basis in the policy. When the policy matures, cash can be paid in a lump sum or using one of the settlement options offered by the insurer. As with other distributions made while the insured is alive, the sum in excess of the cost basis is taxable as ordinary income. Policy Loans If a policyowner takes out a loan against the cash value of a life insurance policy, the amount of the loan is not taxable. This is true even if the loan is larger than the amount of the premiums paid in. The loan is not taxed as long as the policy is in force. If the policy lapses with a loan outstanding, the excess over cost basis becomes taxable as ordinary income. The interest paid on a permanent life insurance policy loan is not tax-deductible. Dividends A participating insurance company s dividend consists of the amount of premium that is returned to the policyowner if the insurance company achieves lower mortality and expense costs than expected. Dividends are paid out of the insurer s surplus earnings for that year. The dividends themselves are not taxable since dividends are considered a return of unearned premium. When dividends: Are left on deposit with the insurance company, interest earned on dividends is taxable as ordinary income in the year earned Received exceed the total premium paid for the life insurance policy, the excess dividends are then considered taxable income Death Benefit Proceeds (Claims) The death benefit, or face amount, of the policy is generally not considered taxable income when paid as a lump sum death benefit to a named beneficiary. If a settlement option is used instead of a lump sum payment, any interest or earnings component of each payment would be considered taxable as ordinary income. Estate Taxes and Benefits Included Benefits may be included in the insured s estate, either intentionally or by default. The policyowner may name the estate as a beneficiary, or by default, if no beneficiary is living at the time of the insured s death, the benefit will automatically be paid into the insured s estate. These values will be added to the amount in the estate and potentially be subject to federal estate taxes. If the policyowner is also the named insured, the proceeds will be added to the value of the insured s estate. It is usually recommended to name an owner other than the insured for this reason. Accelerated Death Benefits The payment of an accelerated death benefit is tax free to a recipient if the benefit payment is qualified. To be a qualified benefit, it must meet the following conditions: A physician must give a prognosis of 24 months or less life expectancy for the named insured The amount of the benefit must at least be equal to the present value of the reduced death benefit remaining after payment of the accelerated benefit 94

3 CHAPTER SEVEN The insurer provides a monthly report for the insured showing the amount paid and the amount of benefit remaining in the life insurance policy Retention Question 1 Under what circumstance would a policy loan in a life insurance policy be taxable? a. Policy loans in life insurance are always tax-free b. If the policyowner dies, the policy loan becomes taxable c. If the policy lapses or is surrendered, any loan amount in excess of cost basis is taxable d. If the insured dies, the policy loan is taxable unless there is sufficient death benefit available to pay off the loan Retention Question 2 To be considered terminally ill, federal law defines a terminal illness as one which is expected to result in the person s death within how many months? a. 36 b. 24 c. 12 d Taxation of Group Life Insurance Premiums Paid by the Employer and the Employee Group Term Life premiums paid by an employer are tax deductible to the business as an ordinary and necessary business expense. Any employee paid premiums are not eligible for a tax deduction. Employer paid premiums in connection with group life insurance do not constitute taxable income to the employee, unless the death benefit paid for by the employer exceeds $50,000. All employer paid premiums for amounts above $50,000 are reported as taxable income to the employee. Death Benefit Proceeds Death benefit proceeds from a group life insurance plan to an employee s named beneficiary are received income tax free. Retention Question 3 When may an employer deduct the premiums it pays for an employee s life insurance benefit? a. As long as the business does not derive a direct benefit from the policy b. If the business does not receive more than 50% of the death benefit c. An employer cannot ever deduct premiums it pays for an employee s life insurance benefit d. Employers can always deduct the premiums it pays for an employee s life insurance benefit 95

4 LIFE AND HEALTH 7.3 Modified Endowment Contracts (MECs) Prior to 1988, individuals could place large sums of money into a cash value policy (typically in a lump sum) and the cash would grow tax deferred until the insured died, at which point a death benefit was paid income tax free. Or if they needed cash, they could take a tax free lifetime loan or withdrawal. These policies were used in place of investment vehicles to avoid paying taxes. Under current law, if a policy is funded too quickly it will be classified as a Modified Endowment Contract (MEC). MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle. 7-Pay Test When a contract does not pass the 7-pay test, it will be deemed a MEC. The 7-pay test is a limitation on the total amount that can be paid into a policy in the first 7 years. It compares premiums paid for the policy during the first 7 years with the net level premiums that would have been paid on a 7-year Pay Whole Life policy providing the same death benefit. As long as the policy premium guidelines are met, the policy will avoid being deemed a Modified Endowment Contract. If a policyowner pays premiums in excess of the guidelines, the excess premium can be refunded by the insurer within 60 days after the end of the contract year. Since a single premium life insurance policy clearly does not pass the 7-pay test, it will automatically be deemed a MEC. The other types of policies that could be classified as MECs are flexible premium policies such as Universal and Variable Universal Life. The flexible premium feature allows the owner to pay premiums on their own schedule. Once a policy is classified as a MEC, it will maintain that classification for the life of the policy. The overfunding cannot be undone in future years. Taxation If a contract is deemed to be a MEC, then any funds that are distributed are subject to a last-in, first-out (LIFO) tax treatment, rather than the normal first-in, first-out tax treatment. Taxable distributions include partial withdrawals, cash value surrenders and policy loans (including automatic premium loans). Penalties If the contract is a MEC, all cash value transactions are SUBJECT TO TAXATION and penalty. Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½. This is considered a premature distribution. Distributions made on or after 59 ½ and distributions paid out due to death or disability are not subject to the penalty. Retention Question 4 If a life insurance policy becomes a MEC, what was the cause? a. The policyowner stopped paying premiums after seven years b. The policy was rolled over into an IRA c. The policy failed the 7-pay test d. The policy was exchanged for an annuity 96

5 CHAPTER SEVEN 7.4 Life Insurance Transfer for Value Rule The transfer-for-value rule was passed by Congress to discourage business transfers of ownership between parties looking to take advantage of the tax free status of life insurance death benefits. If a life insurance policy is transferred to a new owner in return for any kind of material consideration, the transfer-for-value rule partially removes the tax exempt status of a life insurance policy. The rule states that the amount of the death benefit that exceeds the value of consideration and any additional premium paid will be taxed as ordinary income. If the transfer qualifies as an allowable exception to the rule, the death benefit will be paid tax free. Example A $500,000 policy is transferred to a new owner and sold for $50,000. After the sale, the new owner pays $10,000 in life insurance premiums while the insured is alive. Upon death of the insured $60,000 ($50,000 + $10,000) of the death benefit is received income tax free to the beneficiary while $440,000 is taxable ($500,000 - $60,000). 7.5 Section 1035 Exchanges Internal Revenue Code Section 1035 allows for the exchange of an existing insurance policy or contract for another without incurring any tax liability on the interest and/or investment gains in the current contract. These tax-free exchanges, known as 1035 exchanges, can be useful if another insurance policy has features and benefits that are preferred or are superior to those found in an existing contract. Policyowners must be aware that surrender charges might still apply on the existing contract, and a new surrender charge period may start after the exchange on the newly acquired policy. Further, the new insurance contract may have higher fees and charges than the old one which will reduce the returns or increase costs for such things as policy loans. Types of exchanges the IRS will allow on a tax-free basis are from: Life insurance to life insurance Life insurance to an annuity Annuity to an annuity Life insurance or annuity to long-term care But NEVER an annuity to life insurance When moving from an existing life insurance policy to a new life insurance policy as part of a 1035 exchange, the new life insurance policy will be issued only after a new application for coverage is received, and the policy is issued and accepted. Retention Question 5 All of the following tax-free exchanges of life insurance and annuities are permitted, EXCEPT: a. Life insurance to an annuity b. Annuity to long-term care insurance c. Life insurance to long-term care insurance d. Annuity to life insurance 97

6 LIFE AND HEALTH 7.6 Taxation of Annuities Individual Annuities Tax-qualifi ed annuities are generally funded with pre-tax dollars. They re also fully taxable at ordinary income rates when money is withdrawn because the premiums paid and subsequent premiums do not establish a cost basis. Non-qualifi ed annuities are generally funded with after-tax dollars. The premium paid for the non-qualified annuity, along with any subsequent premiums, establishes the cost basis for the non-qualified annuity. In simple terms, the cost basis equals the total amount paid for a deferred annuity. The basis is the starting point for establishing gain or loss. Any interest or other gains during the accumulation phase of the annuity are tax-deferred. If the policy is cashed out for a lump-sum, then any amount received in excess of the cost basis is taxable as ordinary income. If the policy is annuitized then the original investment is returned in equal tax-free installments over the payment period. These payments are not taxed since they are simply a return of principal while the balance of monies received in annuity payments is the taxable gain or earnings. This is taxed at ordinary income tax rates even if the gains come from the investment separate accounts found within a variable annuity. Exclusion Ratio In general, the way in which taxation of annuities is computed is referred to as the exclusion ratio. The IRS has tables and formulas to determine which part of the income benefit payment is tax-free return of premium and which part is taxable. After the entire cost basis is recovered then any future income benefit payments received are fully taxable. A withdrawal is any amount distributed from the annuity that is not part of the annuitization process. Investments are taxed on a last-in, first-out basis (LIFO). That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract. Additionally, withdrawals made prior to the annuitant s age 59 ½ are generally subject to a 10% early withdrawal penalty. To determine which part of each payment is taxable and which is not, the IRS allows the annuitant to use an exclusion ratio. According to the IRS, the part of each annuity payment that represents the cost basis is in the same proportion that the investment in the contract is to the expected return. The expected return is affected by the settlement option chosen and is based on the total amount the annuitant can expect to receive under the contract. For variable annuity income payments, determining the amount of each payment that is tax free is by dividing the investment in the contract by the total number of periodic payments expected to be received, based on the settlement option selected under the contract. The income tax due is based on the annuitant s ordinary income tax rates. Distributions at Death When the annuitant dies during the accumulation phase of the annuity, the beneficiary receiving the death benefit must pay income tax on any gain embedded in the policy, at ordinary income tax rates. 98

7 Estate Taxation CHAPTER SEVEN During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner s estate for valuation. If the annuitant dies during the annuity payout phase, the remaining value in the account will be added to the deceased annuitant s estate for valuation. However, if the annuitant was receiving income from a Pure or Straight Life annuity, the company keeps the balance and nothing goes into the annuitant s estate for valuation. Corporate-Owned Annuities An annuity contract owned by a non-natural person is not treated as an annuity for federal income tax purposes, so the contract s gains are currently taxed as opposed to being tax deferred. In short, there are no tax benefits when an annuity is owned by a corporation. 7.7 Federal Tax Considerations for Retirement Plans Qualified vs Nonqualified Plans Qualified plans must meet the requirements of ERISA (Employee Retirement Income Security Act), which is a federal law that sets minimum standards for pension plans in private industry. ERISA does not require any employer to establish a pension plan. It only requires that those who establish plans must meet certain minimum standards. ERISA qualified plans: Must benefit employees and beneficiaries May not discriminate in favor of highly compensated employees Must be approved by the IRS Have a vesting requirement Qualified plans receive favorable tax treatment. Employer contributions are immediately tax deductible to the employer at the time the contribution is made. These contributions are not taxable to the employee until withdrawn. Employee contributions are either pretax or tax deductible. Distributions taken prior to 59 ½ are subject to taxation and a 10% penalty. The penalty may be waived for death, disability, qualified education costs, medical expenses, first-time home buyers and substantial equal payments over life expectancy. Because most qualified plans defer taxes, retirees must begin taking taxable distributions at age 70 ½. There is a tax penalty if these withdrawals are not made. Nonqualified plans do not meet requirements of federal law to be eligible for favorable tax treatment. Because of this, contributions to a nonqualified plan are not tax deductible. In many cases, such as a nonqualified annuity, the earnings are still tax deferred until withdrawn. Upon withdrawal, only the earnings are taxable Executive Bonus Plans are considered to be nonqualified plans. An executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee. The employer may be able to deduct salary and compensation under Section 162 of the Internal Revenue Code (IRC). Since this plan is designed to provide a salary to the employee upon retirement, the premiums within limits are tax deductible to the employer and the income is taxable to the employee when paid out. These plans are nonqualified because they are designed to discriminate in favor of highly compensated key employees. While the employer pays the initial premiums, additional funds can be deposited by the employee. 99

8 LIFE AND HEALTH Retention Question 6 The federal law that governs the rights of plan participants and beneficiaries of most employer-sponsored benefit plans is. a. COBRA b. HIPAA c. FCRA d. ERISA 7.8 Individual Retirement Accounts (IRAs) Because IRA s are established by individuals, they are not considered qualified plans. IRAs are described in Section 408 of the Tax Code and have their own set of rules. This means an individual can set up a traditional or Roth IRA, whether or not the employer has established a qualified plan at work. Traditional IRAs Anyone under the age of 70½ who has earned income may open an IRA. Contributions may be tax deductible in whole or part (or nondeductible if the owner is a participant in an employersponsored retirement plan and gross income exceeds certain thresholds). A nonworking spouse can also set up a Spousal IRA based on the working spouse s income. Contributions grow taxdeferred until they are withdrawn. There is a maximum annual contribution allowed by the IRS, as well as a catch up contribution for persons age 50 and older. All amounts contributed pre-tax plus gains withdrawn from an IRA are fully taxable as ordinary income. Distributions Withdrawals, known as Required Minimum Distributions (RMDs), from the account must start by April 1 of the year following the year the owner turns age 70½. Failure to take all or part of an annual RMD incurs a 50% penalty tax on the amount not distributed. Premature Distributions Withdrawals before age 59½ are generally subject to a 10% penalty tax. IRAs may be funded using mutual funds, common stock, certificates of deposit, or annuities; but not life insurance. Life insurance does not meet the IRS qualifications of an IRA. An IRA account owner may take an early withdrawal without a penalty tax when certain qualified events occur, such as: Death or permanent disability Up to $10,000 for the down payment on a home as a first time home buyer Medical expenses not covered or reimbursed by health insurance, or to pay health insurance premiums Qualified educational expenses Roth IRA A Roth IRA is a nondeductible tax-free retirement plan for anyone with earned income. Maximum annual contribution limits apply as set by the IRS, plus a catch up contribution for persons age 50 or older. 100

9 CHAPTER SEVEN Unlike a traditional IRA, contributions are not tax deductible. As long as the account has been open for at least 5 years and the owner is at least 59½, proceeds under a qualified distribution are received tax free. Taxpayers can also take a tax-free and penalty-free distribution of earnings in cases of a death, disability or qualified first-time home purchase. A non-qualified distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies. If a person owns a traditional IRA and a Roth IRA, the combined contributions to both cannot exceed the annual maximum IRA contribution for one IRA. Rollovers and Transfers of IRAs The IRS permits an IRA rollover from one account to another or a transfer. This may avoid taxation as an early withdrawal. Rollover If the payment is made directly to the IRA owner, he/she will have 60 days to deposit the check into a new IRA to avoid taxes and penalties. This type of transaction is reported to the IRS and is only allowed once per year. A 20% withholding of funds is required unless a direct rollover occurs. A direct rollover applies when the funds are transferred from one qualified plan to the trustee of an IRA or another plan. While this is reportable, the income is not taxable and therefore no 60-day requirement. IRA Transfer In many cases, IRA assets can be transferred directly into a new account. An IRA transfer is the movement of funds between the same type of plan, such as two IRA accounts. The money is transferred directly from one financial institution to another. Transfers are not taxable and can take place as often as desired. Retention Question 7 A Roth IRA is unique for which of the following reasons? a. Contributions are tax deductible and distributions are nontaxable b. Contributions are nondeductible and distributions are nontaxable c. Contributions are nondeductible and distributions are taxable d. Contributions are tax-deductible and distributions are taxable 7.9 Qualified Retirement Plan Types, Characteristics and Purchasers There are two broad categories of qualified retirement plans: Defined Benefit Plan A defined benefit plan provides employees with a fixed and known benefit at retirement, the amount of which depends upon length of service and highest attained salary. The company assumes the responsibility for making sure money will be available to fund a pension for retiring workers. Defined Contribution Plan A defined contribution plan provides employees with a retirement benefit based on the value of the employee s account at retirement. The employer and employee or both can make contributions. This is a type of retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee. 101

10 LIFE AND HEALTH Characteristics of some Qualified Plans are: Savings Incentive Match Plan for Employees (S.I.M.P.L.E.) A SIMPLE plan may be established either as an IRA or a 401(k) plan. The employer s contribution must be immediately vested at 100%. This means that the employee is entitled to all the employers contributions immediately. SIMPLE plans are only available to companies that have fewer than 100 employees and must be the only type of plan the company has available for the employees. An advantage of a SIMPLE plan is the elimination of high administrative costs. Simplified Employee Pensions (SEPs) Simplified Employee Pensions (SEPs) are set up by any private sector company that does not offer another type of qualified plan. This plan is very popular with self - employed individuals. The SEP plan uses employer funded IRA s. The employer makes contributions and deducts the payments as a business expense. All distributions to employees are taxable upon receipt. Self-Employed Plans (HR-10 or KEOGH Plans) KEOGH Plans, or HR-10 Plans, are available to unincorporated sole proprietors and their eligible employees. Silent partners are not eligible. Contributions for eligible employees are mandatory and based on the percentage of contribution made by the employer for his or her own account. These contributions are deductible. Before a tax law change in 2001, Keogh Plans were a popular choice for high-income selfemployed people. Today, they ve been largely replaced by SEP IRAs, which have the same contribution limits but much less paperwork. Profit-Sharing and 401(k) Plans A 401(k) Plan is a defined contribution plan for employees of for-profit companies. It is an elective deferral plan or salary reduction. 401(k) Plans also can be profit-sharing plans allowing an employee a choice between taking income in cash or putting the income into a qualified plan and deferring that portion of income. If employees elect a defined contribution plan: Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period. The employer must deduct that amount from pay and forward to the plan custodian on a timely basis. Participants typically invest in a portfolio of mutual funds. Employers may contribute and match funds to participant accounts as long as the contribution formula is not discriminatory. If the plan is incorporated as a profit sharing plan: The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least 3 out of 5 consecutive years. Tax-Sheltered Annuities (TSAs) Tax-Sheltered Annuities (TSA) are qualified annuity plans benefitting employees of public schools under the Internal Revenue Code (IRC) Section 403(b), as well as other nonprofit organizations qualified under Section 501(c)(3). Employees of nonprofit organizations may have an arrangement with the employer whereby the employer agrees with each participating employee to reduce the employee s pay by a specified amount and invest it in a retirement fund or contract for the employee. Employees do not make direct payments to the retirement fund. 102

11 CHAPTER SEVEN These accounts are owned by the employee and are nonforfeitable and will be paid upon death, retirement, or termination of the employee. Contributions are pre-tax and interest earned grows tax deferred. State College Tuition Plans 529 Plans A 529 State College Tuition Plan is operated by a state or educational institution. These plans offer tax advantages when saving for college and other post-secondary training for a designated beneficiary. Contributions are not tax deductible, however earnings are not subject to federal tax (and typically not state tax) when used for qualified education expenses of the designated beneficiary (child or grandchild). Retention Question 8 What is defined in a defined contribution plan? a. The percentage or amount of an employee s deposits to the plan b. The percentage or amount of an employee s distributions from the plan c. The percentage of the employee s income provided as life insurance to the employee d. The employer s percentage or amount of distribution to an employee from the plan Retention Question 9 A Tax Sheltered Annuity may be established and funded by which of the following? a. A not-for-profit community hospital association b. XYZ s Catering, a small unincorporated business c. Johnson Accountants, Inc. d. A professional law firm CHAPTER SEVEN LIGHTNING FACTS 1. Premiums for personal uses of life insurance are not tax deductible In a cash value policy, income tax on any gains is deferred until the policyowner withdraws the cash value In the event of a partial or full surrender of a cash value policy, any amount of cash value that exceeds the premiums paid (the cost basis) will be taxable as income in the year it was distributed Policy loans are not taxable at the time of distribution Interest paid to the insurer, if any, for a policy loan is not tax deductible to the policyowner A participating cash value policy may receive dividends from the insurance company. Dividends are paid from the insurer s surplus earnings for that year Dividends are considered by the IRS as a refund of excess premiums rather than profit or gain for the policyowner, and are not taxable as a result If dividends are left with the insurer to accumulate at interest, the annual interest credited to prior dividends is taxable as ordinary income The paid up additions dividend option provides for additional cash value insurance to be added to the existing insurance without evidence of insurability Death benefit proceeds from life insurance are generally received by the beneficiary income taxfree. However, any interest that accrues following the death of the insured prior to the payment of the death benefit to the beneficiary is taxable as income to the beneficiary

12 LIFE AND HEALTH 11. A beneficiary who receives the policy proceeds in any manner other than a lump sum receives a combination of death benefit principal plus interest on the principal left with the insurance company. The interest is taxable, but the principal is income tax-free The Accelerated Death Benefit is a rider or provision that permits the policyowner to access the death benefit prior to the insured s death in the event the insured becomes terminally ill To be considered terminally ill, the insured must be diagnosed by a physician as having less than 24 months of remaining life expectancy Accelerated Death Benefits are considered an advance payment of the death benefit, but must be qualified, which means that certain conditions must be met The value of the death benefit is includable in the estate of the deceased insured if the insured had any incidents of ownership in the policy Premiums paid by a business for group life insurance on its employees as a benefit are tax deductible to the business. As long as the insurance amount is not more than $50,000, there is no income tax liability for the employee, even if the premium is paid in full by the employer When an employee s life insurance benefit exceeds $50,000, the amount of premium paid by the employer for the portion of the benefit in excess of $50,000 should be reported as taxable income to the employee, so that the entire death benefit is tax-free to the beneficiary The Modified Endowment Contract ( MEC ) is a cash value policy that accumulates too much cash value in the first seven years of the policy (usually due to the payment of excess premiums) The 7-Pay Test of cash value accumulation or premiums paid is the benchmark that determines the MEC/non-MEC status of the policy in the first seven years in the contract (such as raising or lowering the death benefit, or exchanging the contract for another life policy) Under the MEC rules, any distributions made before the policyowner s age 59½ are subject to the 10% early withdrawal penalty tax, with the exception of distributions due to the death or total disability of the insured Single premium whole life policies, by definition, are MECs, because they are funded too quickly. Universal life policies are the most likely forms of cash value insurance to become MECs due to overfunding. An ordinary whole life policy is generally immune from becoming a MEC because it cannot be overfunded The ownership of a life insurance policy may be transferred to a new owner at any time prior to the death of the insured. For death proceeds to remain tax free to the beneficiary, the transfer of ownership must qualify for an exception IRC 1035 permits the exchange of life insurance and annuity contracts and avoids the imposition of income tax on the cash value in the surrenders leading to the exchange The permissible 1035 exchanges include Life to Life, Life to Annuity, and Annuity to Annuity exchanges, but not Annuity to Life Distributions from nonqualified annuities are taxable as to gain only. 26. Annuity benefits payable to a beneficiary upon the death of the annuitant are taxable if they are a gain embedded in the policy If the annuity payments cease entirely upon the annuitant s death, there is no estate tax liability. Amounts distributable to a beneficiary are includable in the policyowner s estate The Employee Retirement Income Security Act of 1974 ( ERISA ) is the federal law that sets minimum standards for pension plans in private industry. ERISA does not require employers to establish pension plans, but does require that retirement plans meet certain minimum standards Employer-sponsored qualified retirement plans may not be designed or administered in a way that discriminates in favor of the most highly compensated employees

13 CHAPTER SEVEN 30. Traditional IRAs permit penalty-free withdrawals in limited circumstances, including a onetime withdrawal of up to $10,000 for the first-time purchase of a home, for certain qualified educational expenses, to pay for unreimbursed medical expenses, or in the event of death or disability of the account owner With a Traditional IRA, pre-tax contributions are reduced or eliminated if a person is a participant in an employer-sponsored qualified retirement plan and has income in excess of specified thresholds At age 70½, contributions to qualified retirement plans must cease and Required Minimum Distributions (RMDs) must begin Benefits received from IRAs and other qualified retirement plans are fully taxable as income if the employee did not pay income tax on the contributions. Most distributions taken prior to age 59½ are also subject to a 10% penalty tax An IRA rollover occurs when some or all of the funds from an IRA or other qualified retirement plan are distributed and subsequently deposited into another IRA within 60 days of the distribution Only one rollover from an IRA is permitted in a 12-month period, but there is no limit on the amount of a rollover. There is no limit on the number of direct rollovers to an IRA from other employer-sponsored qualified plans A direct transfer from an IRA happens when the account assets are sent from one custodian to a new custodian without being distributed to the account owner. The participant does not receive any income. There is no limit to the number or value of direct transfers which may be made in a year A Roth IRA is a unique plan whose contributions are not tax deductible. Qualified distributions under current tax law will be income-tax free after age 59½ and the account has been open for at least five years A variety of employer-sponsored qualified retirement plans are available, including SIMPLE, SEP, Keogh, 401(k), TSA (also known as 403(b)), and profit sharing plans. SIMPLE plans are only available to employers with 100 employees or less and when no other qualified plan is in place A Keogh plan is available to unincorporated sole proprietors and their eligible employees. Contributions for eligible employees are mandatory and based on the percentage of contributions made by the employer for his own account A 401(k) plan is a defined contribution plan for employees of for-profit companies. Employees define their contribution amount as a percentage of income or a fixed dollar amount per payroll period, and the employer must deduct that amount from pay and forward to the plan custodian on a timely basis A profit sharing plan may be a stand-alone plan or incorporated as a component of a 401(k) plan. The employer defines the circumstances under which profit-based contributions will be made, and contributions must generally be made in at least three out of five consecutive years A TSA (Tax sheltered annuity) is a defined contribution plan for public school employees under a 403(B) or a non-profit organization under the internal revenue code 501(c)(3)