Retirement and Other Life Insurance Concepts — practice questions

6.2% of the exam ≈8 real questions 9 free questions here

Qualified plans, group life, key person and buy-sell coverage, life settlements and the tax treatment of premiums and proceeds: about 8 of the 130 scored questions.

Where people lose points

• A MEC is taxed on gain first (LIFO) with a 10% penalty before 59½.
• The first $50,000 of employer-paid group term is tax-free to the employee.
• Death benefits are generally income-tax-free; interest on installments is not.
• A 1035 exchange can move life to annuity, never annuity to life.

Questions and answers, explained

All 8 questions above, with the correct answer and why it is correct. Everything here is on retirement and other life insurance concepts.

1. A cash value life insurance policy becomes a modified endowment contract (MEC) when:

   • AIts cash value at any point during the contract exceeds the policy’s stated death benefit
   • BThe policy is exchanged under Section 1035 within seven years of its original issue date
   • CThe owner takes a policy loan against the cash value during the first seven years
   • DPremiums in the first seven years exceed the seven-pay net level premium limitCorrect

   Why: The seven-pay test compares cumulative premiums actually paid in each of the first seven contract years against the seven-pay net level premium; exceeding it at any point makes the contract a MEC. Choice C reverses cause and effect — a loan does not create MEC status, but a loan taken from a contract that is already a MEC is a taxable distribution. Outline IV — taxation of life insurance.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

2. Which of the following exchanges will NOT qualify for tax-free treatment under Section 1035?

   • AA life insurance policy exchanged for an annuity
   • BAn annuity exchanged for another annuity
   • CAn annuity exchanged for a life insurance policyCorrect
   • DA life insurance policy exchanged for a qualified long-term care contract

   Why: Section 1035 allows exchanges in one direction only: life to life, life to annuity, annuity to annuity, and life or annuity to a qualified long-term care contract. An annuity may never be exchanged into life insurance, because that would convert taxable annuity gain into a tax-free death benefit. Choices B and D are both expressly permitted. Outline IV.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

3. At age 55, a man withdraws $25,000 from a nonqualified deferred annuity he funded with $80,000 of after-tax premium. The contract is now worth $130,000. How is the withdrawal taxed?

   • AEntirely tax-free, as a return of his cost basis
   • BThe full $25,000 is ordinary income, plus a 10% penaltyCorrect
   • C$9,615 is taxable, using an exclusion ratio
   • DThe $25,000 is taxed as long-term capital gain

   Why: Withdrawals from a deferred annuity issued after August 13, 1982, come out gain-first on a LIFO basis; with $50,000 of gain in this contract the entire $25,000 is ordinary income, and the 10% penalty applies because he is under 59½. Choice C misapplies the exclusion ratio, which governs annuitized payments under a settlement option — not lump-sum withdrawals during the accumulation period. Outline IV.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

4. Under current federal law, at what age must an individual born in 1955 begin required minimum distributions from a traditional IRA, and which account requires no distributions during the owner's lifetime?

   • AAge 70½; a Roth IRA requires none
   • BAge 72; a traditional IRA requires none
   • CAge 73; a Roth IRA requires noneCorrect
   • DAge 75; a SEP IRA requires none

   Why: SECURE 2.0 set the required beginning age at 73 for people who turned 72 after 2022 and reach 73 before 2033, rising to 75 for those born in 1960 or later; the first distribution may be deferred to April 1 of the following year. Roth IRA owners are never required to take lifetime distributions, which is why choice A is right on the account but wrong on the outdated 70½ age. Outline IV.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

5. A 70-year-old who is neither terminally nor chronically ill sells his $500,000 policy in a life settlement for $130,000. He has paid $70,000 in premiums, and the policy's cash surrender value is $95,000. How is his $60,000 gain taxed?

   • AAll $60,000 is long-term capital gain
   • BAll $60,000 is ordinary income
   • C$25,000 is ordinary income and $35,000 is long-term capital gainCorrect
   • DNothing is taxable, because life insurance proceeds are excluded from income

   Why: Life settlement proceeds are taxed in three tiers: tax-free up to the $70,000 basis; ordinary income from basis up to the $95,000 cash surrender value, which is $25,000 of inside build-up; and long-term capital gain on the $35,000 above cash surrender value. Since the 2017 tax law, basis is total premiums paid with no reduction for the cost of insurance, so answers that give the whole $60,000 a single tax character (A or B) misapply the tiers. Outline IV.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

6. Which of the following is a characteristic of a qualified retirement plan?

   • AEmployer contributions are tax-deductible when made, and plan earnings grow tax-deferredCorrect
   • BThe plan may discriminate in favor of highly compensated executives
   • CThe plan does not need to meet IRS requirements or receive IRS approval
   • DDistributions at retirement are always received income-tax-free

   Why: A qualified plan meets IRS requirements in exchange for tax advantages: the employer deducts contributions when made, and earnings accumulate tax-deferred until distributed. Qualified plans must not discriminate in favor of highly compensated employees — the ability to discriminate is the hallmark of nonqualified plans such as deferred compensation. Distributions of pre-tax contributions and earnings are taxed as ordinary income when received, so option D is also wrong. Outline IV.D (qualified vs. nonqualified plans).

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

7. At age 50, Carlos funds a cash value life insurance policy with a single premium of $100,000, and the contract fails the seven-pay test, making it a modified endowment contract (MEC). At age 52, when the contract has $30,000 of gain, he withdraws $20,000. What is the tax consequence?

   • AThe withdrawal is a tax-free return of premium under FIFO ordering rules
   • BOnly the amount exceeding his premium basis is taxable, with no penalty
   • CThe withdrawal is entirely tax-free, but the policy’s death benefit becomes taxable
   • DThe entire $20,000 is taxed as ordinary income under LIFO, plus a 10% penaltyCorrect

   Why: Distributions from a MEC — withdrawals and loans alike — are taxed on a LIFO basis, meaning gain comes out first, and taxable amounts distributed before age 59½ also incur a 10 percent penalty. Because the contract holds $30,000 of gain, the entire $20,000 withdrawal is gain and is fully taxable plus the penalty. Option A describes the FIFO treatment that applies to withdrawals from non-MEC life policies, and option C is wrong because the death benefit remains income-tax-free even in a MEC. Outline IV.G (tax treatment — MECs); IRC §7702A.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

8. Which statement about a modified endowment contract (MEC) is correct?

   • ADeath benefit proceeds paid to the beneficiary lose their income-tax-free treatment entirely.
   • BPolicy loans are received income-tax-free, exactly as they are with a non-MEC policy.
   • CA loan is a taxable distribution of gain first, with a 10% penalty before age 59 1/2.Correct
   • DWithdrawals are treated as a tax-free return of basis first, on a FIFO basis.

   Why: MEC status changes only the taxation of lifetime distributions: loans, withdrawals and assignments come out gain-first (LIFO) and are taxable to the extent of gain, plus a 10% penalty on the taxable amount before age 59 1/2 absent an exception. Option B is the closest distractor and states the ordinary non-MEC rule that loans are not taxable, which is precisely what MEC status removes. Option A is wrong because the death benefit paid to a beneficiary remains income-tax-free even in a MEC.

   Reference Texas outline #124401, general section IV (Retirement and other insurance concepts)

Topics inside this domain

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• Social Insurance (4.6%)

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