CLU Income Taxation Principles 2 — Questions and Answers
Question 1: Under IRC Section 101(a), life insurance death benefits paid to a named beneficiary are generally:
- Fully taxable as ordinary income
- Excluded from gross income (Correct answer)
- Subject to capital gains tax
- Taxable only on amounts exceeding the policy's cash value
Correct answer: Excluded from gross income
IRC Section 101(a) provides that life insurance death benefits are generally excluded from the beneficiary's gross income.
Question 2: A policy owner surrenders a life insurance policy with a cash value of $80,000 and a cost basis (premiums paid) of $50,000. What is the taxable gain?
- $0, because life insurance is always tax-free
- $80,000 as ordinary income
- $30,000 as ordinary income (Correct answer)
- $30,000 as capital gain
Correct answer: $30,000 as ordinary income
The gain on surrender is cash value minus adjusted cost basis ($80,000 - $50,000 = $30,000), taxed as ordinary income.
Question 3: Which of the following describes the tax treatment of dividends received on a participating life insurance policy?
- Always taxable as ordinary income in the year received
- Tax-free return of premium until they exceed total premiums paid (Correct answer)
- Subject to the qualified dividend tax rate
- Excluded from income permanently under IRC Section 72
Correct answer: Tax-free return of premium until they exceed total premiums paid
Policy dividends are treated as a non-taxable return of premium until the cumulative dividends exceed total premiums paid.
Question 4: The 'transfer for value' rule under IRC Section 101(a)(2) causes life insurance death benefits to become taxable when:
- A policy is placed inside an irrevocable trust
- A policy is sold or transferred for valuable consideration (Correct answer)
- The insured changes occupations after policy issuance
- A beneficiary designation is changed
Correct answer: A policy is sold or transferred for valuable consideration
When a life insurance policy is transferred for valuable consideration, the death benefit becomes taxable to the extent it exceeds the transferee's basis.
Question 5: Interest earned on life insurance policy loans is generally:
- Fully deductible as investment interest
- Not deductible for personal policies under IRC Section 264 (Correct answer)
- Deductible only if the policy is a modified endowment contract
- Deductible up to the net investment income limit
Correct answer: Not deductible for personal policies under IRC Section 264
IRC Section 264 generally disallows deductions for interest paid on loans against personally owned life insurance policies.
Question 6: A Modified Endowment Contract (MEC) differs from standard life insurance primarily in that distributions from a MEC are taxed under:
- FIFO (first-in, first-out) basis
- LIFO (last-in, first-out) basis with a 10% penalty on pre-59½ distributions (Correct answer)
- Capital gains rules regardless of owner's age
- IRC Section 101(a) exclusion rules
Correct answer: LIFO (last-in, first-out) basis with a 10% penalty on pre-59½ distributions
MECs are subject to LIFO taxation, meaning gain comes out first and is subject to ordinary income tax plus a 10% penalty if taken before age 59½.
Question 7: For federal income tax purposes, premiums paid by an employer for group term life insurance coverage up to what face amount are excluded from an employee's gross income?
- $25,000
- $50,000 (Correct answer)
- $100,000
- $250,000
Correct answer: $50,000
IRC Section 79 excludes employer-paid group term life insurance premiums from employee income for the first $50,000 of coverage.
CLU Income Taxation Principles 2
Under IRC Section 101(a), life insurance death benefits paid to a named beneficiary are generally: