Ask the Experts – October 24, 2014

Question: My client’s CPA believes that the death benefit from a modified endowment contract is income taxable. Is the CPA correct?

Answer: No.

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:

http://www.investopedia.com/terms/m/modified-endowment-contract.asp

Ask the Experts – October 3, 2014

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are there ways to minimize income taxes on Social Security retirement benefits?

Answer: Taxpayers often try to minimize the amount of their Social Security retirement benefits subject to taxation with a number of strategies. Particularly, taxpayers can delay filing for Social Security and use their available retirement accounts or assets in the meantime.

For example, let’s say Maude plans to retire at age 62 and needs $40,000 per year on which to live. Also assume that Maude’s PIA is $2,000 per month, or $24,000 per year.

If Maude files at age 62, she will receive $18,000 per year from Social Security ($24,000 reduced by 25%), and presumably make up the extra $22,000 per year from her tax-deferred retirement accounts. Therefore, the $22,000 is added to her adjusted gross income, and her provisional income is $31,000 ($22,000 AGI + ½ of $18,000 Social Security benefits). Since Maude’s provisional income exceeds $25,000, she includes $3,000 of her Social Security benefits in her gross income (i.e. half of the excess of $31,000 provisional income over $25,000 base amount).

Let’s say Maude files at age 70 instead, where she would earn delayed retirement credits at 8% of her PIA per year. In this case, her benefit would be $31,680 per year, requiring her to take out only $8,320 per year from her personal retirement accounts. Her provisional income in this situation is $24,160 ($8,320 AGI + ½ of $31,680 Social Security benefits); therefore, no portion of her Social Security retirement benefits would be taxable.

We’ve purposefully used elementary examples to show how delaying Social Security while using other means until filing for benefits can help avoid taxes on one’s Social Security benefits. We did not take into account the myriad variables that should be taken into account when deciding whether to file for benefits early or later.

Additionally, there are other ways to reduce provisional income. For example,

Keep assets inside qualified retirement plans, since distributions from tax-qualified plans are generally added to AGI.

Liquidate tax-qualified retirement plans before filing for Social Security benefits.

Invest in after-tax retirement plans, such as Roth IRAs or designated Roth qualified accounts.

As usual, the benefits of reducing the amount of Social Security benefits should be weighed against the costs of each of these strategies.

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Ask the Experts – September 25, 2014

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are Social Security benefits subject to income taxes?

Answer: It depends on the taxpayer’s other income. Up to 85% of an individual’s Social Security benefits could be taxable. This doesn’t mean the taxpayer can lose up to 85% of her benefits; it simply means the taxable portion of her benefits may be added to gross income and taxed at her normal tax rates.

The first step in calculating what, if any, portion of a taxpayer’s Social Security retirement benefits are taxable, the taxpayer must calculate her provisional income for the year. Provisional income is generally the sum of:

(1) The individual’s adjusted gross income (AGI);
(2) Her tax-exempt interest (e.g., interest from municipal bonds); and
(3) Half of her Social Security benefits.

For example, if an individual’s AGI is $22,000, and she earns $3,000 of interest from tax-exempt municipal bonds and $14,000 in Social Security benefits, her provisional income is $32,000 ($22,000 AGI + $3,000 tax-exempt interest + ½ of her $14,000 Social Security benefits).

The next step is to compare the individual’s provisional income to the base amount and adjusted base amount. The applicable base amount depends on filing status:

Filing Status	Base Amount	Adjusted Base Amount
Non-married individual	$25,000	$34,000
Married filing jointly	$32,000	$44,000
Married filing separately and lived apart during the year	$25,000	$32,000
Married filing separately and lived together during the year	$0	$0

The base amounts are not indexed for inflation.

If provisional income is less than or equal to the applicable base amount, none of the taxpayer’s Social Security retirement benefits are taxable. If the provisional income is larger than the base amount, a portion of the benefits may be taxable.

For a taxpayer whose provisional income exceeds the applicable base amount, but not the adjusted base amount, she must include in gross income the lesser of:

50% of the excess provisional income over the base amount; or
50% of the Social Security benefits received that year.

For example, suppose Maude, who files as an unmarried taxpayer, had $30,000 provisional income with $12,500 in Social Security retirement benefits. Her provisional income exceeded her base amount by $5,000 ($30,000 provisional income over the $25,000 base amount), which is less than her $12,500 Social Security benefits; therefore she will include half of the excess amount, $2,500, in her gross income for the year. This results in her paying taxes on 20% ($2,500 of her $12,500 yearly benefit) of the benefits she receives.

Additionally, if a taxpayer’s provisional income exceeds the applicable adjusted base amount, 85% of the excess is generally taxable. However, the highest total percentage of Social Security retirement benefits that may be taxable is 85%.

Here’s an example. Say that Maude received a Social Security retirement benefit of $24,000 last year. Also assume she had other income of $30,000 for the year, making her provisional income $42,000 ($30,000 AGI plus ½ of half her $24,000 retirement benefits).

For the first $9,000 of provisional income over the base amount, but less than the adjusted base amount, the tentative amount taxable is $4,500 (50% of $9,000).

For the extra $8,000 of provisional income over the base amount, the tentative amount taxable in this segment is $6,800 (85% of $8,000).

The sum of these two segments is $11,300, meaning she tentatively adds this amount to her gross income. We say these amounts are tentative because she can’t add more than 85% of her total Social Security benefits to gross income. Since 85% of her $24,000 Social Security benefits ($20,400) is more than the tentative amount of $11,300, $11,300 of Maude’s Social Security benefit is taxable.

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Question of the Day – June 22

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Here’s the question of the day.

Question: Do Native Americans living on a reservation pay federal income taxes and estate taxes?

Answer: Yes. As U.S. citizens, Native Americans are subject to U.S. income and estate tax law.

Here’s an excerpt from the Bureau of Indian Affairs website:

Are American Indians and Alaska Natives citizens of the United States?
Yes. As early as 1817, U.S. citizenship had been conferred by special treaty upon specific groups of Indian people. American citizenship was also conveyed by statutes, naturalization proceedings, and by service in the Armed Forces with an honorable discharge in World War I. In 1924, Congress extended American citizenship to all other American Indians born within the territorial limits of the United States. American Indians and Alaska Natives are citizens of the United States and of the individual states, counties, cities, and towns where they reside. They can also become citizens of their tribes or villages as enrolled tribal members.

Do American Indians and Alaska Natives pay taxes?
Yes. They pay the same taxes as other citizens with the following exceptions:

Federal income taxes are not levied on income from trust lands held for them by the U.S.
State income taxes are not paid on income earned on a federal Indian reservation.
State sales taxes are not paid by Indians on transactions made on a federal Indian reservation.
Local property taxes are not paid on reservation or trust land.

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Question of the Day – October 25

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Here’s the question of the day.

Question: How is a life insurance policy transferred from a business to an employee valued for income tax purposes?

Answer: Revenue Procedure 2005-25 created new rules for how life policies transferred in conjunction with employment are to be valued. While the IRS did not create the final word on fair market value in 2005-25, it did provide a safe harbor method for calculating a policy’s value.

The safe harbor value of a life policy is the greater of

the interpolated terminal reserve plus unearned premium (ITR), or
the product of the PERC amount and the average surrender factor.

PERC stands for premium, expenses, and reasonable charges. Stated simply, the PERC amount is premiums, plus dividends and other cash value earnings, minus actual mortality charges and other reasonable charges. Any distributions taken from the contract prior to its valuation would also reduce the PERC value. For most transfers related to employment, the PERC value is unadjusted by the policy’s surrender charges.

What is the PERC value of a life policy? Generally speaking, it’s an amount approximately equal to the gross cash value for most universal life-style contracts.

As with gift tax transfers, we recommend that the policy owner start with his or her insurance agent to get a calculation for the ITR and PERC values for a life policy being transferred in connection with employment. After those numbers are obtained, the clients should check with their own tax advisors to decide how to report the transaction for income tax purposes.

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