Quick Answer
Annuities can accumulate value or provide retirement income. Group life covers eligible members under a sponsor's master policy. Businesses use life insurance for key-person protection or buy-sell funding. General federal tax treatment depends on the contract, ownership, premium source, amount received, and whether the payment is earnings, returned investment, interest, or death proceeds.
What Are the Main Insurance Uses and Risks?
- Annuity: A fixed annuity places investment risk supporting its guarantees primarily on the insurer, subject to claims-paying ability. A variable annuity places market risk on the owner. Review liquidity, access to money when needed, and surrender charges, contract charges that can reduce early withdrawals or surrender proceeds during the stated charge period. Compare fees, payout choices, and tax deferral, which postpones tax on earnings until distribution.
- Funding: A single-premium annuity uses one purchase payment. A flexible-premium annuity allows a series of payments under the contract.
- Income start: An immediate annuity begins income soon after purchase and typically uses a lump sum. A deferred annuity begins income at a future date and may accept one payment or flexible payments over time.
- Group life: A sponsor owns the master policy, the contract governing group coverage. Each covered member usually receives a certificate describing coverage under that policy; it does not make the member the master policyowner. Contributory means members pay some or all of the premium; noncontributory means the sponsor funds it all.
- If the current plan gives a member the right to choose a beneficiary, master policy ownership alone does not let the sponsor replace that member's valid choice.
- In a fully insured group life plan, the sponsor owns the master policy, while the insurer is responsible for covered claims under that contract.
- Conversion and portability: Conversion creates an individual policy; portability continues coverage through a group arrangement. Availability, timing, amount, health questions, and premium follow the contract and applicable law. A converted policy has its own price; the old group rate and employer funding do not automatically continue.
- Key-person life: In the usual arrangement, the business owns coverage on the key person and receives the death proceeds to address its financial loss. Disability protection exists only when the contract adds it.
- Buy-sell funding: Insurance supplies money for a purchase required by a written ownership agreement. The policy alone does not create the purchase obligation.
- Life settlement: The owner transfers an existing policy to a third-party buyer for value. The buyer becomes owner, generally pays future premiums, and receives the death benefit. Tax, privacy, creditor, eligibility, and state-law consequences require separate review.
How Are Common Life Policy Amounts Generally Taxed?
| Amount | General federal treatment |
|---|---|
| Personal life premiums | Usually nondeductible personal expenses |
| Death proceeds paid because of the insured's death | Generally excluded from the beneficiary's gross income, subject to exceptions |
| Interest paid with or on retained death proceeds | Generally taxable |
| Full cash surrender | Proceeds above adjusted tax cost are generally taxable income |
Adjusted policy investment, also called tax cost or investment in the contract, can reflect applicable adjustments. When a problem requires a surrender-gain calculation, use the adjusted amount supplied in the facts.
Example: Full-surrender proceeds are $28,000, and the supplied adjusted policy investment is $22,000.
- Subtract the supplied adjusted policy investment from the proceeds: $28,000 − $22,000 = $6,000 taxable gain.
If proceeds do not exceed the stated tax cost, this comparison produces no gain. It does not by itself establish a deductible loss.
A modified endowment contract (MEC) has different federal rules for lifetime policy distributions. Status can arise when a life policy fails the seven-pay test or is received in exchange for an existing MEC. The test compares cumulative premiums with a funding limit based on seven level annual premiums for future benefits.
MEC withdrawals generally take taxable gain before returned investment, and loans can count as distributions. The Retirement Plans, Social Security, and MEC Tax lesson explains the rules and exceptions.
Exam Tip: Gotchas
- Interest paid with death proceeds can be taxable even when the death benefit itself is generally excluded.
How Are Annuity Payments Taxed?
| Tax arrangement | Meaning |
|---|---|
| Qualified annuity | Held under a retirement arrangement that meets federal tax requirements. |
| Nonqualified annuity | Purchased outside those arrangements, commonly with after-tax money, income already subject to tax. |
- Tax deferral during accumulation postpones tax; it does not exempt distributed earnings.
- A nonqualified periodic payment can contain taxable earnings and a permitted return of after-tax investment.
- A payment from a qualified arrangement with no after-tax investment to recover is generally fully taxable. Other special rules can change the result.
- Roth arrangements use contributions included in taxable income. Distributions meeting their tax-free-payment requirements can be excluded from income; check the actual arrangement and payment.
- Total tax-free recovery generally cannot exceed investment in the contract. After the investment is fully recovered, later payments are generally fully taxable.
- Withholding does not determine how much of a payment is taxable.
Example: A $900 payment includes $250 of permitted investment recovery.
- Identify the tax-free portion under the stated facts: $250.
- Subtract it from the payment: $900 − $250 = $650 taxable.
When Can Group Life Create Imputed Income?
Imputed income is taxable value assigned to a noncash benefit. Under the general federal group-term life rule:
- Exclude the cost of the first $50,000 of coverage.
- Apply the current monthly cost per $1,000 of excess coverage for the employee's age at year-end.
- Multiply by the covered months.
- Subtract the employee's after-tax payments.
Example: Coverage is $70,000. The question supplies a monthly rate of $0.10 per $1,000 for 12 months and $12 of after-tax employee payments.
- Find coverage above the exclusion: $70,000 − $50,000 = $20,000.
- Convert it to $1,000 units: $20,000 ÷ $1,000 = 20 units.
- Find the annual table cost: 20 × $0.10 × 12 = $24.
- Subtract the employee payments: $24 − $12 = $12 taxable value.
Use the current Internal Revenue Service table and check employee and plan exceptions. The taxable amount is the calculated cost, not the full death benefit.
Exam Tip: Gotchas
- Imputed coverage income and the later tax treatment of death proceeds are separate questions.
- Key-person protection covers a business loss; buy-sell funding supports an ownership purchase.
What Should You Check on Exam Day?
- Who owns, funds, is insured by, and receives each policy benefit?
- Is the amount a premium, death benefit, interest, surrender proceeds, returned investment, or earnings?
- Which general rule applies, and what stated exception or contract term could change it?