Question: If a business transfers a life insurance policy insuring the life of an employee to the employee are there any tax consequences?
When a business transfers a life insurance policy to an employee without consideration the value of the policy is taxable to the employee as compensation. For transfers after February 2004, the Treasury Regulations generally treat the policy’s gross cash value as the income tax value of the compensation.
Where the employee is a stockholder of the corporation, the value of the policy may be treated as a dividend if the exchange was part of a stock redemption plan.
On the other hand, if an employer transfers a policy to an employee or shareholder, if the employee’s or shareholder’s rights in the life policy are subject to a risk of forfeiture, the full value of the policy is not taxable until the employee’s rights become substantially vested.
Question: If my client receives Social Security survivor benefits from her deceased spouse and then gets re-married, is she still eligible for the survivor benefits?
Answer: It depends.
If your client re-marries before age 60, she cannot receive survivor benefits as a surviving spouse while married. If, however, remarriage occurs after age 60, the client will continue to qualify for benefits on her deceased spouse’s Social Security record.
If the client re-marries after 60 and stays married long enough to become eligible for spousal benefits, she may be eligible for three types of benefits: one based on the deceased spouse’s record, another based on the new spouse’s record and the third based on her own record. While she may be eligible for three different types of benefits, the Social Security Administration will generally pay ONLY whichever benefit is the highest.
Your client may be able to collect a certain type of benefit now and then switch to a higher benefit later.
Question: My client has an IRA with substantially equal periodic payments set up in order to avoid the additional tax on early distributions. Can she roll out part of the funds in the IRA if they are not needed to satisfy the SEPP requirements?
As we discussed in the preceding question and answer, substantially equal periodic payments can be established as a way to avoid the additional 10% tax on distributions from a qualified account if money is needed before a person reaches 59 ½. A person who has established a SEPP plan cannot modify the payments or the account. If a modification occurs, the IRS will go back and retroactively apply the additional 10% penalty tax on all of the distributions that have been made from the account pre 59 ½. The IRS however allows for a modification or termination of the SEPP plan when the owner reaches the age 59 ½ or has taken the SEPP distributions for 5 years, whichever is longer.
If a person tries to roll over part of the money in an account being used for SEPP distributions, the IRS will consider the SEPP plan busted. The IRS will apply the additional 10% tax to all of the prior distributions taken to that point.
Question: If my client activates the income rider on my annuity, does that qualify for the substantially equal periodic payments exception to the early distribution penalty?
Answer: Not necessarily.
The IRS gives us three methods under Code Section 72(t) to determine substantially equal periodic payments in order to avoid the 10% additional tax on distributions taken from qualified accounts before age 59 ½. The methods can be found in Revenue Ruing 2002-62, they are:
- Required minimum distribution method
- Amortization method
- Annuitization method
Each of these methods requires its own calculation based upon the account value and the life expectancy of the account owner. Simply receiving a set amount each year from an income rider does not necessarily meet these calculation requirements.
The payments from the income rider would have to exactly equal to the Section 72(t) substantially equal periodic payments determined by one of these methods to qualify as an exception to the additional tax on early distributions.
There is a free calculator for Section 72(t) distributions at http://72t.net/72t/Sepp/Calculators.
Question: If my client makes a transfer of his life insurance policy to his daughter, does that violate the transfer for value rule?
Answer: Probably not, so long as the transfer is made by gift.
Internal Revenue Code Section 101(a) says that life insurance death proceeds are usually income tax free. Subsection (2) of that Code Section says that there are certain circumstances under which it is possible for the death benefit to become income taxable. The circumstances arise when a policy is transferred for valuable consideration to anyone except:
- The insured
- A partner of the insured
- A partnership that includes the insured as a partner
- A corporation of which the insured is an officer or shareholder.
In this case, the transfer is from the insured to his daughter. Since the daughter is not an exempt transferee according to the preceding list, we should rightly be worried about the transfer for value rule.
If the client in this case receives anything of value in return from his daughter for making the policy transfer to her, it will be a transfer for value—and the death proceeds of the life insurance policy paid to her will be subject to income taxes. On the other hand, if the client makes a gift of the policy to the daughter, the transfer is not “for value” and thus the death benefit will still be income tax free.
Question: Does a divorce nullify my client’s ex-spouse as a life insurance beneficiary?
Answer: It depends on the relevant state’s laws.
Several states have enacted legislation that works to effectively nullify an ex-spouse as a primary beneficiary for an insurance policy. One of these states is the State of Florida. In 2012 the state passed F.S. 732.703 which voids the designation of a former spouse as a beneficiary of an interest in an asset that will be transferred or paid upon the death of the decedent if:
- The decedent’s marriage was judicially dissolved or declared invalid before the decedent’s death and
- The designation was made before the dissolution or order invalidating the marriage.
If this law applies the asset will pass as if the former spouse predeceased the decedent. This can create a number of consequences. If there is a contingent beneficiary named then the asset will go to the contingent beneficiary. If there is no contingent beneficiary, the asset will likely end up as part of the decedent’s probate estate. Probate assets are subject to the probate process, and therefore become potentially accessible by the decedent’s creditors. The probate process also tends to be long and drawn out, which delays the beneficiary’s ability to access the asset as well. Your client may want the ex-spouse to remain the beneficiary despite the divorce. These laws would frustrate that desire. An individual could affirm the beneficiary designation after divorce in order to name that ex-spouse as beneficiary.
For these reasons it is important for financial professionals to stay in contact with clients and remain up to date on their life situations. A check on clients’ current life circumstances might save a lot of headaches later as well as present the opportunity to address clients’ changing needs.
Question: Do IRA distributions count as income for the Affordable Care Act (ACA)?
Answer: Yes, any taxable portion of an IRA distribution is included in income for determining whether or not an individual qualifies for tax credits or cost assistance subsidies under the ACA.
Beginning in 2014 an individual’s Modified Adjusted Gross Income (MAGI) is used to determine whether or not a person will be eligible for insurance premium tax credits or cost assistance subsidies. The ACA uses the same calculations to determine MAGI as the IRS.
MAGI is determined by figuring a person’s Adjusted Gross Income (AGI) and then adding back certain income. Generally AGI includes all of your taxable income for the year minus certain adjustments. Many of the items that are deducted from income to determine AGI are actually added back to arrive at MAGI. Most importantly, some types of income that are not included in AGI are added to determine MAGI–for example, the non-taxable portion of social security, and tax-exempt interest is included in MAGI, but not in AGI. For many folks this means their MAGI is higher than their AGI.
The taxable portion of an IRA distribution is included in AGI, and is therefore also included in MAGI. The taxable portions of IRA distributions are just one of many types of income included in MAGI. For more information on determining MAGI please see the IRS’s Modified Adjusted Gross Income Computation worksheet.
Question: I have a client turning 70 ½ this year in 2015. I know she is still eligible to contribute to a Traditional IRA for 2014, but not for 2015. If she opens a new IRA and contributes $6,500 for 2014, will she have to take a required minimum distribution for 2015 from that account?
IRS Publication 590 Individual Retirement Arrangements clarifies that an individual can make contributions to their IRA for a given year until the due date for filing their tax return for that year, not including extensions. In other words an individual generally has until April 15, 2015 to make a contribution to their IRA for 2014.
Publication 590 also gives us the rules for determining when required minimum distributions must start and how to calculate them. An individual must receive at least a minimum amount from their IRA beginning with the year they turn 70 ½. In order to figure the amount for the required minimum distribution, the account balance as of December 31 for the preceding year is divided by the applicable distribution period or life expectancy factor for the individual.
In this case the individual client made the initial contribution in 2015 for year 2014. Since the account was opened in 2015, there is no account balance as of December 31 2014. Because there is a zero account balance as of December 31, 2014 there is no required minimum distribution due for 2015 from this account. The client will have to take required minimum distributions from this account in 2016 and for the following years.
Question: My client’s CPA believes that the death benefit from a modified endowment contract is income taxable. Is the CPA correct?
The authority for this answer requires stitching together a few different parts of the Internal Revenue Code.
Section 101(a) says that the death benefit of a life insurance policy is generally income tax free.
(a) Proceeds of life insurance contracts payable by reason of death
(1) General rule
Except as otherwise provided in paragraph (2), subsection (d),subsection (f), and subsection (j), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.
Section 7702 defines life insurance, and sets out the kinds of guideline premium tests that must be met for a contract to qualify. MEC life policies must (and do) meet the tests in Section 7702.
Section 7702A explains how the separate seven-pay test works. Contracts that fail to meet the 7702A seven-pay test are MECs—but they are also still life insurance, because they meet the tests in Section 7702.
Finally Section 72(e)(10) explains that MECs are taxed differently from “normal” life policies for the purpose of lifetime distributions. Nothing in Sections 7702A, 101 or 72 says that MECs are taxed differently from normal life policies with regard to the death proceeds. Therefore, the death proceeds of a MEC life policy are income tax free.
There are lots of third party sources online that confirm the same conclusion. Here’s a link to one:
Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers. Here’s the question of the day.
Question: I have a 50 year old client who recently did an in-service conversion of her 403b account to a designated Roth account. She now wants to take a hardship distribution from her designated Roth account. Does she have to worry about the 10% penalty tax on the distribution of converted amounts?
Just as with regular Roth IRA conversions, there is a special tax rule about withdrawing converted amounts within five years of the conversion. Here is the applicable Q & A from Notice 2010-84.
Q-12. Are there any special rules relating to the application of the 10% additional tax under § 72(t) for distributions allocable to the taxable amount of an in-plan Roth rollover made within the preceding 5 years?
A-12. Yes, pursuant to §§ 402A(c)(4)(D) and 408A(d)(3)(F), if an amount allocable to the taxable amount of an in-plan Roth rollover is distributed within the 5-taxable-year period beginning with the first day of the participant’s taxable year in which the rollover was made, the amount distributed is treated as includible in gross income for the purpose of applying § 72(t) to the distribution.
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