Advanced Underwriting Consultants

Question of the Day – October 19

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Here’s the question of the day.

Question: What are the tax consequences allowing a non-MEC life insurance policy with an existing loan to lapse or be surrendered?

Answer: In taxing policy distributions, the cost recovery rule is used; that is, distributions from a contract are first set off against basis, and generally no tax liability is recognized until basis has been exceeded.  This is the reason advisors suggest that income from policies be taken as withdrawals to basis first and loans thereafter.

A non-MEC life policy with loans may, when terminated, create an income tax liability even though little or no cash is received by the owner at termination.  This is often referred to as phantom income.

Here’s an example.  Assume the policyowner surrenders the following contract.

Cash surrender value $8,353.00
+ Total loans + $66,466.00
= Total distribution amount = $74,819.00
– Basis ($3,802 annual premium x 10 years )  

– 38,020.00

= Ordinary income = $ 36,799.00
   

The policyholder will receive a check upon surrender for $ 8,353, but may owe income tax in excess of that amount.

Likewise, when a policy simply lapses because it doesn’t have enough cash value to stay in force, any loan balance owed at the time of lapse will be considered to be a taxable distribution.

Situations such as these can result in phantom income with a vengeance.

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Question of the Day – October 18

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Here’s the question of the day.

Question: What are the tax consequences of making a gift of a life insurance policy subject to a loan?

Answer:   The gift of a policy in which the outstanding loan exceeds the owner’s basis may create an income tax liability not only to the donor upon transfer of the policy, but also to the donee upon the death of the insured.

The reason for this disastrous turn of events is the transfer of a policy with a loan exceeding basis is treated not as a gift, but as part-gift, part-sale.  The consideration, or sale price, is the donee’s assumption of the outstanding loan.  Code Section 1001(b) states amount received from a sale consists of the sum of cash plus the fair market value of property received other than cash.  Regulation 1.1001-2(a) says that amount received includes “the amount of liabilities from which the transferor is discharged as a result of the sale or other transfer.”

Let’s assume the owner of the $1 million death benefit policy in the following example decides to gift it to a child or an irrevocable trust.

Cash surrender value $  8,353.00
Total loans $66,466.00
Basis ( $ 3,802 premium x 10 years ) $ 38,020.00

The cash value, $8,353, is considered to be a gift.  An amount equal to the outstanding loan is considered to be a sale.  Thus, the owner receives $66,466 (assumption of the outstanding loan by the new owner) for property with a basis of $38,020.  The owner must report ordinary income of $28,446 on the transaction.

Furthermore, the donee will be taxed at the insured’s death.  Code Section 101 provides any transfer for a valuable consideration of a right to receive all or part of the proceeds of a life insurance policy is a transfer for value.  The donee’s assumption of the policy loan is considered to be valuable consideration.

Where a life policy is transferred for value, the amount of its death proceeds excludable from income is limited to consideration paid for the policy by the transferee plus any further premiums.  Unless the transaction falls under one of the exceptions to the transfer for value rule, the donee will owe income tax on the death benefit to the extent it exceeds her basis in the policy.

The donee’s basis in the policy is determined according to the rules set out in Regulation 1.1015.  In a part sale, part gift transaction, the donee’s unadjusted basis in the transferred property is equal to the gift tax paid by the donor plus the greater of (1) the consideration paid or deemed to have been paid by the donee, or (2) the donor’s adjusted basis in the property.

In our example, the donor paid no gift tax, therefore the donee’s unadjusted basis in the policy is $66,466 (the greater of $66,466 or $38,020).  Suppose the donee continues the policy and pays $50,000 in premiums prior to the insured’s death.  To the extent the donee receives death proceeds exceeding $116,466 ($66,466 plus $50,000), she must pay income tax on the excess.  In this example, that means $883,534 of the death benefit that’s taxable.

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Question of the Day – October 14

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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 divorcing her spouse, and they are in the process of splitting up a pension plan balance.  What are the tax consequences of doing so?

Answer: When a taxpayer withdrew funds from his IRA in order to satisfy a divorce judgment, he was required to include the distribution in his gross income.  The Tax Court also ruled the distribution was subject to the 10% penalty imposed on early IRA withdrawals.

The divorce judgment failed to meet the requirements of a qualified domestic relations order (QDRO).

Under the facts of the case, taxpayer was required to pay his ex-wife a specified amount of money pursuant to their property settlement agreement.  In an effort to comply with the agreement, he attempted to transfer funds directly from his IRA to his former spouse.  She, however, refused to accept the transfer over concern that the funds would be taxable to her when she eventually received distributions from her IRA.  Ultimately, ex-husband simply withdrew the money from his IRA and delivered it directly to his ex-wife.  He did not report the IRA withdrawal on his return.

The Tax Court noted that retirement plan distributions made under a QDRO are not currently taxable to the taxpayer making the transfer. However the Court rejected taxpayer’s contention that the divorce judgment was, in effect, a QDRO.  According to the Court, the judgment only directed that he make a specific cash payment to his ex-wife.  It did not order him to withdraw funds from his IRA.  In addition, husband didn’t actually transfer an interest in the IRA to his former spouse.  Instead, he merely took a withdrawal and paid the funds to her.

 

In general, qualified retirement plans must provide that plan benefits may not be assigned or alienated.  However, a plan may distribute, segregate, or otherwise recognize the attachment of any portion of a participant’s benefits in favor of the participant’s spouse, former spouse or dependents, if such action is mandated by a QDRO.

A QDRO is a judgment, decree, or order (including an order approving a property settlement) that relates to the provision of child support, alimony, or property rights to a spouse, former spouse, child or other dependent (“alternate payees”); is made under a state’s community property or other domestic relations law; creates, recognizes, or assigns the right to receive all or a portion of a participant’s plan benefits to an alternate payee; and clearly specifies,

  • the name and address of the alternate payee,
  • the amount or percentage of the benefit to be paid,
  • the number of payments or period over which the order applies, and
  • each plan to which the order applies.

Strictly speaking, a QDRO applies only to an employer-sponsored retirement plan such as a pension or profit-sharing plan, but Code Section 408 sets out similar provisions for IRAs.

A QDRO cannot provide an alternate payee with any form of benefit not otherwise available to the plan participant.

A QDRO may also specify that a former spouse of a participant be treated as the surviving spouse for purposes of survivor benefit requirements.  For this purpose, the former spouse will be treated as married to the participant for the requisite one-year period if such former spouse had been married to the participant for at least one year.

Under a QDRO, a spousal alternate payee (including a former spouse) is taxed like any other distributee of a qualified plan distribution.

The 10% premature distribution penalty which applies to qualified plan distributions taken prior to age 59-1/2 does not apply to payments made to an alternate payee pursuant to a QDRO.  This rule does not apply in the case of an IRA; distributions from an IRA not rolled over will be subject to the premature 10% distribution penalty.

If a spouse or former spouse of the participant receives a distribution under a QDRO, the rollover rules apply to such alternate payee as if the alternate payee were the participant. Thus, the alternate payee can avoid having to include such a distribution in his or her taxable income by rolling the money into an IRA within 60 days, or by asking the pension trustee to make a direct transfer.

For those helping clients make pension or IRA transfers pursuant to a divorce or separation, make sure it’s a QDRO.

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.

Question of the Day – October 13

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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: I have a client who wants to access money from her IRA prior to age 59 ½.  How can she avoid the 10% premature distribution penalty on money she receives?

Answer: To avoid the penalty, many take distributions that are “part of a series of substantially equal periodic payments (sometimes called a SEPP) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and his designated beneficiary.”  See Revenue Code Sec.72(t)(2)(A)(iv).

The IRS issued Revenue Ruling 2002-62, addressing rules governing this exception to the 10% penalty.  The ruling sets out three acceptable methods for determining payments under a series of substantially equal periodic payments:

(1) the required minimum distribution (RMD) method,

(2) the fixed amortization method, and

(3) the fixed annuitization method.

Each of the three methods requires use of a life expectancy table. The taxpayer can elect

  • the Uniform Lifetime Table,
  • the single life expectancy table, or
  • the joint and last survivor table.

Once chosen the table cannot be changed from year to year.

Methods (2) and (3) require the use of an interest rate assumption.  Revenue Ruling 2002-62 states that the interest rate used must not exceed 120% of the applicable mid-term rate for either of the two months preceding the month in which distribution begins.

Under the RMD method, the account balance is determined each year on a valuation date.  There is some flexibility in choosing the valuation date, but it is usually December 31.  The account balance is divided by the life expectancy determined from the applicable life expectancy table using the taxpayer’s age on the birthday falling within the distribution year. Using this method, there is a re-calculation of the payout each year.

Under the fixed amortization method, the initial account balance is determined.  That amount is amortized over the appropriate life expectancy using an interest rate not to exceed the limits set out above.  Once the initial payment is determined, it does not change but remains constant over the life of the arrangement.

Using the fixed annuitization method, an interest rate is selected (not to exceed the limits set out above) and using the appropriate mortality table, an annuity factor is derived.  The initial account balance is divided by the annuity factor and a payment determined.  Once determined, the payment does not change over the life of the arrangement.  The easiest way to get this number, in practice, is to ask a life insurance company for a quote.

Once a series of substantially equal periodic payments is commenced, it must continue for at least five years or until age 59-1/2, whichever comes last.  If the arrangement is terminated or the payments are changed prior to that time, the taxpayer will be assessed the 10% penalty plus interest for all payouts prior to the later of five years or age 59-1/2.

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.

Question of the Day – October 12

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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: What are the differences between an owner-driven non-qualified deferred annuity (NQDA) and an annuitant-driven NQDA?

Answer: “Annuitant-driven” and “owner-driven” are not tax terms, nor even terms that are fully-defined or agreed-upon within the life insurance community.  The names create two very loose categories of contracts which may give a vague suggestion of how and when death benefits will be paid out with regard to that category of contract.

Older NQDAs are typically annuitant-driven.  In an annuitant-driven contract, the owner may be changed, but the annuitant may not.  On the death of the annuitant, the contract matures and a death benefit is payable to the beneficiary in whatever manner the contract specifies.

During the life of the annuitant, the owner typically retains the contractual right to change the beneficiary, make partial surrenders, or totally surrender the contract and receive the surrender proceeds.  In these regards, annuitant-driven NQDA contract provisions are similar to life insurance policies.

Newer contracts tend to be owner-driven.  In an owner-driven NQDA, the owner has the ability to change the annuitant under circumstances specified in the contract.  The death of the annuitant does not necessarily cause the maturity of the contract—although it depends on the words in the contract.   If the annuitant dies, and if the contract doesn’t automatically mature, all that happens is the owner names a new annuitant.  However, if the owner dies, the contract is payable to the beneficiary in the manner the contract specifies.

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.

Question of the Day – October 11

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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 wants to exchange two life policies—one covering the husband, the other covering the wife—for a new survivorship policy under Code Section 1035.  Is that allowed?

Answer: No.

In exchanges of life insurance policies, the insureds on both the old and new policies must be identical.  In Private Letter Ruling 9542037, the Service ruled the exchange of a single life policy on the husband for a joint life policy on husband and wife was not tax-free because the insureds weren’t identical.  Similarly, the exchange of two policies – one on the husband and one on the wife – for a new joint policy on husband and wife didn’t qualify as a 1035 exchange.

The converse also holds true; a joint life policy on husband and wife cannot be exchanged tax-free for two individual policies, one on husband, one on wife.

However, the Service did rule in Private Letter Ruling 9330040, that it’s possible to do an exchange of a joint policy after the death of one of the insureds for a single life policy on the survivor.

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.

Question of the Day – October 10

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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 owns a permanent life policy with a loan against it.  He wants to exchange the policy for a new, loan-free policy.  Is that allowed?

Answer: Section 1035 of the Internal Revenue Code allows a taxpayer to exchange life policies for new ones without paying tax on the gain.

However, there are policy transfers which may not qualify as tax-free exchanges.  One such transfer is the exchange of a life policy with an outstanding loan.  Money or other property received as part of an exchange is known as “boot.”

If a policy, in which the owner has a gain, is exchanged for a new one and the loan on the old policy disappears as part of the transaction, the owner must recognize taxable boot.  The boot is the lesser of the loan repaid or the gain in the policy.

In several private letter rulings, the IRS has held a policy may be exchanged tax-free for another policy, if the new policy is subject to the same amount of indebtedness as the old one.

If the new insurance company will not issue a policy with a loan against it the taxpayer has two options:

(1) pay off the loan on the old policy with funds from another source and then borrow on the new policy, if necessary; or

(2) exchange the policy, “bite the bullet” and pay the tax generated when the loan on the old policy is extinguished.

The IRS may find taxable boot in a step transaction.  In Private Letter Ruling 9141025, a taxpayer owned a life insurance policy bought with a single premium of $1 million; there was a $448,000 outstanding loan on the policy.  The taxpayer proposed to pay off the loan through a partial surrender (withdrawal) from the policy.

The taxpayer expected to treat the withdrawal as a tax-free return of premium.  The plan was to then exchange the remaining cash value for a new policy and treat it as a 1035 exchange.

Smartly, the taxpayer asked the question before doing the act.  IRS held the proposed transaction would cause taxable boot equal to the extinguished $448,000 loan; the policy withdrawal would not be an independent transaction but part of a step transaction.

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.

Question of the Day – October 4

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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: What is modified adjusted gross income (MAGI), and why is it important?

Answer: MAGI is used in many important decisions regarding IRAs.  For example, any taxpayer may make a traditional IRA contribution, but if the taxpayer (or spouse) is covered by an employer retirement plan, the deductibility of the contribution phases out at certain levels of MAGI.  Further, a taxpayer may be ineligible to make Roth IRA contributions if MAGI is too high.

Here are a few tips about MAGI, which are related to questions we often get asked.

  • MAGI is not reduced by deductible traditional IRA contributions
  • Capital gains are included in MAGI
  • MAGI can be reduced by contributing to 401(k) or 403(b) plans

Here’s a quick way to calculate MAGI using Form 1040.  Take the last number on the bottom of the first page of the return, “adjusted gross income,” and recalculate it by adding back in the following amounts:

  • IRA deduction
  • Student loan interest deduction
  • Exclusion of qualified savings bond interest shown on form 8815.
  • Tuition and fees deduction
  • Domestic production activities deduction
  • Foreign earned income exclusion
  • Foreign housing exclusion or deduction
  • Exclusion of employer-provided adoption benefits shown on Form 8839.

In addition, two special rules apply to Roth IRAs:  If the taxpayer does a Roth conversion during the tax year, the income reported as a result of the conversion is not included in MAGI for Roth IRA purposes.  Likewise, if the participant had to take a distribution from a traditional IRA in order to meet the RMD rules, the amount equal to the RMD is not included in MAGI for Roth 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.

Question of the Day – October 3

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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: What is a standby irrevocable life insurance trust (standby ILIT) and how is it used?

Answer: A standby ILIT is a strategy for a married couple to own survivorship life insurance, giving the spouses current access to cash value while planning for removing the insurance from the taxable estate in the future.

Say that husband and wife are insured under a second to die policy.   If husband is expected to have the shorter life expectancy, he is named as initial owner of the policy.  Spouse is named as primary contingent owner and an unfunded ILIT (the standby ILIT) is named as secondary contingent owner.  The ILIT is drafted and executed, however it is left in standby mode.  Nothing beyond a nominal amount is transferred to the trust.

While husband is alive, he has full access to cash value accumulations in the policy.  He can use those accumulations tax-free to supplement retirement income by withdrawing cash values up to basis and borrowing amounts in excess of basis.

At the husband’s first death, wife becomes the owner of the policy.  If there are no estate tax concerns, she becomes the owner of the policy and can continue to utilize cash values for supplemental retirement income.  She can direct the death proceeds directly to her beneficiaries or to a trust set up for their benefit.

If estate taxes are a concern, the wife can disclaim her interest in the second to die policy.  Her disclaimer allows the policy to pass to the secondary contingent owner, the ILIT.  The cash value of the policy is an asset in the husband’s estate and will force utilization of his exemption amount.  If the cash value is greater than the exemption amount, then estate taxes will have to be paid.  Since the disclaimer by the wife results in her never having owned the policy, she is not a transferor for purposes of Section 2035 and the three-year look back rule will not apply.

If, on the other hand, the wife dies first, husband continues to own policy and utilize cash values as needed.  He can direct the death proceeds directly to his beneficiaries or to a trust set up for their benefit.

If estate taxes continue to be an issue, at wife’s death, husband can absolutely assign the second to die policy to the ILIT.  Section 2035’s three-year rule does apply and the gift is a taxable gift subject to the $5 million gift tax exemption amount.  However, once the three years transpires, the death proceeds will be excluded from the husband’s taxable estate.

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.