Advanced Underwriting Consultants

Ask the Experts – August 5, 2015

Question:  If a business transfers a life insurance policy insuring the life of an employee to the employee are there any tax consequences?

Answer:  Yes.

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.

Ask the Experts – July 2, 2015

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?

Answer:   No.

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.

Ask the Experts – March 17, 2015

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.

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 6, 2014

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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?

Answer:  Yes.

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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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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Ask the Experts – June 13, 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: My client (age 62, resident of Colorado) owns an IRA. Are IRA distributions subject to state income tax? If he wants to do a Roth conversion, will it be subject to state income tax?

Answer: It depends on the state. Colorado imposes a flat 4.63% state income tax is on its residents’ federal taxable income. Since both IRA distributions and Roth conversions are taxable on the federal level, they are both generally taxable on the Colorado state level.

However, Colorado allows a pension/annuity subtraction for taxpayers who are age 55 or older as of the last day of the tax year, or who are receiving a pension or annuity because of the death of the person who earned it. The pension/annuity subtraction allows a Colorado taxpayer to reduce his taxable income by the taxable amount he receives as a distribution from his IRA, up to $20,000 (or $24,000 if age 65 or older).

For example, suppose your client accurately reported $60,000 as taxable income on his federal income tax return. Generally, your client would owe $2,778 (4.63% of $60,000) in state income taxes. But suppose that $20,000 of his taxable income came from a distribution from his IRA. He can exclude this $20,000 distribution, resulting in a new taxable base of $40,000.

Additionally, the pension/annuity subtraction rule applies to Roth conversions. Therefore, as long as your client converts $20,000 or less to a Roth IRA in the taxable year, and doesn’t use the pension/annuity subtraction on another taxable distribution throughout the year, he may exclude the converted amount from the Colorado income tax.

Each state has different rules when it comes to income taxes, and there’s no universal rule as to the taxability of IRAs at the state level.

Sources: Col. Rev. Stat. § 39-22-104(f)(4); FYI Income 25: Pension/Annuity Subtraction, http://www.colorado.gov/cms/forms/dor-tax/Income25.pdf.

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Ask the Experts – May 27

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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 403(b) contributions subject to employment taxes?

Answer: The simple answer is yes—although employee deferrals are not treated as current income for federal income tax purposes, they are included as “wages” and subject to social security, Medicare, and federal unemployment taxes (FUTA).

However, employer contributions are not subject to such employment taxes as long as the contributions:

    • Are mandatory for all employees covered by the retirement system.
    • Are a salary “supplement” and not a salary reduction—i.e. the employer must not reduce employee salary to offset the amount designated as employee contributions.

Therefore, contributions to employer-sponsored plans could be labeled as “employer contributions,” but still be considered employee contributions for social security, Medicare, and FUTA purposes.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – May 22

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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: Can severance pay be contributed toward a 403(b) tax-sheltered annuity?

Answer: Although a participant in a 403(b) plan contribute up to a $17,500 of her salary to the plan in 2014, the participant cannot contribute more to a 403(b) plan than she earns as compensation for the year. Whether severance pay constitutes “compensation” depends on when the participant receives it.

The general rule is that compensation does not include severance pay if it is paid after severance from employment. Treas. Reg. § 1.415(c)-2(e)(3)(iv). For example, if your client was fired early in 2014, but will receive 6 months of severance pay in 2014, then she cannot contribute to the 403(b) plan.

If the severance pay is actually payment for unused sick, vacation, or other leave, or if the payment is received as part of a nonqualified unfunded deferred compensation plan, then the payments are considered “compensation” and therefore may be deferred to the 403(b) plan.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – April 23

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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: My client is planning on filing an extension to file her taxes. Does she have to have a valid reason to be granted an extension? If she gets an extension, is she required to pay her taxes by April 15, or by the end of the extension?

Answer: An extension to file is automatic, but it isn’t an extension to pay.

There are two penalties to note when filing taxes. First, there’s the failure to file penalty which is generally equal to 5% per month of the unpaid balance. The good news is that the IRS allows an automatic six-month filing extension, meaning the 5% penalty wouldn’t start accruing until October 15 at the earliest. All the taxpayer has to is either file Form 4868 or go to IRS.gov and get extra time through its “Free File” link.

The second penalty is the failure to pay penalty which is generally 0.5% per month plus interest (currently 3% per year). Obtaining an extension to file does not remove the failure to pay penalty. When your client files for the extension, she will be asked to estimate her tax liability, and if she wants to avoid the monthly penalty and interest, she should pay the estimated taxes. She can get a refund if her estimated taxes are more than she’s actually required to pay.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.