Advanced Underwriting Consultants

Question of the Day – November 28

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Here’s the question of the day.

Question: My client owns a life insurance policy that is a modified endowment contract (MEC).  If the client uses the policy as collateral for a bank loan, will the amount of the loan be potentially taxable to the client?

Answer: Yes.

Code Section 72(e) provides the following rule that applies to MEC contracts and nonqualified annuities:

        (A) Loans treated as distributions
          If, during any taxable year, an individual -
            (i) receives (directly or indirectly) any amount as a loan
          under any contract to which this subsection applies, or
            (ii) assigns or pledges (or agrees to assign or pledge) any
          portion of the value of any such contract,
        such amount or portion shall be treated as received under the
        contract as an amount not received as an annuity.  

For a MEC contract, an amount not received as an annuity is taxable to the extent there is gain in the contract.  If the policy owner is younger than 59 ½, the gain portion is also subject to the 10% penalty tax.

If the loan balance grows and the policy continues to collateralize the loan balance, the incremental annual increases in loan value are also potentially taxable distributions.

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Question of the Day – November 22

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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: My client is 75 and still working at an employer sponsoring a 401K plan.  The client intends to take a complete distribution of the 401K plan balance and roll it into a traditional IRA.  The client will continue to work for the rest of this year.  Is an RMD required from the 401K plan balance prior to its rollover to the IRA?

Answer: The IRS hasn’t specifically addressed this situation, but we feel that based on current rules the answer is no.

Here’s the analysis.  For the 401K plan, Revenue Code Section 401(a)(9)(C) applies to when the required beginning date occurs:

(C) Required beginning date. For purposes of this paragraph—

(i) In general. The term “required beginning date” means April 1 of the calendar year following the later of—

(I) the calendar year in which the employee attains age 70 1/2 , or

(II) the calendar year in which the employee retires.

Since the employee is still working, based on Section 401, there’s no RMD required from the 401K plan.

Must the taxpayer take the RMD for the 401K account from the IRA after rollover, but before the end of the calendar year?  RMDs are clearly due from the IRA because the client’s older than 70 1/2.  However the rules for calculating the RMD from an IRA is to use December’s balance from the previous year—prior to the rollover.  So our analysis is that there is no RMD required in the year of the rollover attributable to the 401K plan balance.

If the taxpayer did not continue to work for the 401K plan sponsor through the end of the year in which the rollover occurred, the result would probably be different.  In that case, an RMD would have been due from the 401K account based on the prior December’s account balance, and that amount would not have been eligible for rollover to an IRA.

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 – November 21

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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: My client’s father passed recently, and she is the beneficiary of his life insurance policy.  Is the life insurance death benefit subject to the claims of the client’s creditors?

Answer: Most likely, yes.

Many states protect the death benefits of life insurance from the claims of the policy owner’s creditors.  In addition, there may be federal protections or probate safeguards that prevent a deceased’s creditors from being able get at life insurance proceeds paid to a named beneficiary.  Those protections generally do not extend to the IRS as a creditor.

On the other hand, life insurance proceeds paid to a beneficiary are not generally protected from the claims of the beneficiary’s creditors.  Once the beneficiary gets the death proceeds, they become cash.  Cash is reachable by creditors.

Check your state rules with a local bankruptcy or asset protection attorney for a final answer on all creditor protection questions.

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 – November 17

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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: My 50 year old client is in the process of getting divorced.  Her husband is a participant in a 401K plan.  They’ve worked out a deal for the husband to transfer $100,000 from the plan to her, pursuant to their divorce.  What are the tax implications?

Answer: Under normal circumstances, the husband would have to pay income taxes on the plan distribution, plus any applicable penalty tax.  To avoid that tax result, the parties should divide the plan pursuant to a qualified domestic relations order (QDRO).

A QDRO is a judgment, decree, or order that relates to the provision of child support, alimony, or property rights to a spouse, former spouse, child or other dependent.  There are a few other technical requirements.

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

A direct distribution from a pension to the non-participant spouse pursuant to a QDRO is taxable but not subject to the pre-59 ½ 10% penalty tax.  If that’s done in the example above, the wife would pay income tax on the 401K balance she receives, but not the penalty tax.

The alternate payee can also roll over the QDRO distribution to her own IRA tax-free.  If the rollover is done, the receiving spouse loses the ability to get penalty tax free pre-59 ½ distributions.

A QDRO-like opportunity also exists for an IRA to be split and rolled over by the non-participant spouse tax-free to his or her retirement account.  However, if an alternate payee of an IRA who is younger than 59 ½ decides to keep the distribution, the payee will be potentially liable for both income tax and penalty tax.

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 – November 16

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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: Are life insurance cash values exempt from tax claims by the IRS?

Answer: No.  Although life insurance and annuity cash values can be exempt form the claims of creditors under relevant state law, those protections do not extend to the claims of the IRS.

Under Section 6321 of the Revenue Code, the IRS can reach the cash value of a life insurance policy to satisfy the policyowner’s tax liability.  Likewise, the IRS can reach the values in a nonqualified annuity in the same manner.  The IRS’s levy against the policy’s cash value will be treated as a taxable distribution to the policyowner.

On the other hand, the death proceeds of a life insurance policy are generally exempt from the claims of the insured’s creditors, if the insured owned the policy and the proceeds are paid to a named beneficiary.  However, a death benefit received by the beneficiary will not usually be exempt from the claims of the beneficiary’s creditors.

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 – November 14

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Here’s the Question of the Day

Question: Is there a compelling reason for the owner of a closely held business to use money from the business to pay for life insurance needed to pay estate taxes?

Answer: Maybe.

There are usually few, if any, income tax reasons to have the 100% owner of a closely held business use business money to pay for needed life insurance.  However, there may be compelling gift tax reasons to do so.

When life insurance is used to pay for estate taxes, the coverage is usually owned by an irrevocable trust (ILIT), or, in the alternative, adult children.  If the insured transfers money to the ILIT or adult children by gift, the insured must deal with the gift tax limitations imposed by the federal and relevant state governments.

If the insured is worried about gift tax limits, it may be possible to access money from the business in different ways to provide the money needed for the premium:

1. A split dollar plan between the business and the ILIT may lower the gift tax cost of the premium.

2. If the adult children are employees of the business, the business may pay them extra to cover the premiums associated with the life insurance policy.

3. The business may be able to lend money to the ILIT or adult children to provide the premium needed for the coverage.

Each of these alternatives may lower or eliminate the gift tax cost associated with the insurance meant to pay the insured’s estate taxes.  However, each alternative has its drawbacks.  Talk with the proposed insured’s estate planning attorney and accountant to decide whether one of these might be the right choice.

Question of the Day – November 8

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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: My client’s CPA says that my client’s business can take a deduction for the life insurance premium if the client is willing to get a taxable death benefit.  Is that true?

Answer: No.

The premium for business life insurance is not deductible for the business, nor is the premium for personal life insurance deductible personally.  See Revenue Code Sections 264 and 262.

Tax advisors sometimes confuse the rules with regard to business life insurance with the rules about disability income coverage.  The premium for disability insurance is treated as accident and health coverage.  The business and participant have the option to treat the premium as deductible by the business and non-taxable by the participant.  If the premium is treated that way, the disability benefit payable to the insured employee will be taxable.  Code Section 106 says that the premiums paid by an employer to a health plan are not included in the employee’s taxable income.  Section 105(a) states that most benefits received by an employee through accident or health insurance for personal injuries or sickness are included in gross income if the contributions by the employer were not included in the employee’s gross income.

On the other hand, the business can pay the premium as a bonus to the employee, and the employee would recognize the premium as taxable income.  If the premium is treated that way, the disability benefit would be tax free.  See Revenue Code Section 104.

We’ve heard that some CPAs recommend waiting until the end of a calendar year to decide whether to treat the disability income premium should be treated as a pre-tax benefit or a taxable bonus.  Waiting arguably allows the insured to hedge his bet about whether a disability benefit paid will be taxable or not.

The same technique does not work with life insurance because there’s no pre-tax option built into the Revenue Code with regard to the premium.

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 – November 3

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Here’s the question of the day.

Question: My client has taken a distribution from an IRA, and is nearing the deadline for being able to re-deposit the money tax free under the 60-day rollover rule.  How rigid is the IRS’s deadline?

Answer: A taxpayer may make a 60-day rollover of an eligible rollover distribution if, after receiving the distribution, the amount is deposited into another eligible plan or IRA.  The taxpayer must make the rollover contribution by the 60th day after receiving the eligible rollover distribution.

The IRS may create a special extension to the 60-day requirement in cases where failure to meet the normal deadline is due to circumstances completely out of the control of the taxpayer.  Extensions are not routinely granted.

A recent Private Letter Ruling, PLR 201021040, gives one example where IRS waived the 60-day time period and allowed a deposit after 83 days to be treated as a tax-free rollover where the taxpayer proved he was erroneously advised by his financial advisor that he had 90 days to complete the transaction.

Under the facts of the PLR, Taxpayer A was the owner of an IRA with Custodian C and wished to do a rollover to Custodian D.  Taxpayer A consulted Financial Advisor B and was told he had 90 days to complete the transaction.  Taxpayer A has documentary proof of the erroneous advice given by Financial Advisor B.  In this case, IRS allowed the tax-free rollover even though the deposit into the new account was 83 days after withdrawal from the old account.

The IRS only grants waivers to the 60-day rollover requirement in limited circumstances.  Here’s what IRS itself says about waivers to the 60-day rollover period in Publication 590:

In determining whether to grant a waiver, the IRS will consider all relevant facts and circumstances, including:

  • • Whether errors were made by the financial institution,
  • • Whether you were unable to complete the rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error,
  • • Whether you used the amount distributed (for example, in the case of payment by check, whether you cashed the check), and
  • • How much time has passed since the date of distribution.

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 – November 2

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Here’s the question of the day.

Question: My client has an IRA with both after-tax contributions, and pre-tax contributions.  The IRA also has untaxed earnings.  Is there any way the client can separate the after-tax contributions and convert that to a Roth IRA?

Answer: For most people, the answer is no.

The problem is that many of these clients already have other IRAs with significant pre-tax contributions in them.  When a conversion of an IRA is accomplished, the conversion amount is considered taxable and non-taxable in the same proportion as the total account balance in the IRA immediately before conversion.

Here’s an example.  Suppose the IRA has a total account balance of $100,000 of which $10,000 represents after-tax contributions and $90,000 is the amount of pre-tax contributions and earnings in the account.  If $10,000 is converted, the conversion will be considered to be $1,000 tax-free as conversion of after-tax contributions, and $9,000 will be the taxable amount representing pre-tax contributions and/or earnings.

Why not just segregate the IRA money into two or more IRAs with all the pre-tax money in one and all the after-tax money in another?  The answer is it can’t be done!  For purposes of determining the taxable portion of a Roth conversion, all IRAs owned by the taxpayer are aggregated together.

For clients with access to an employer plan such as a 403(b) or 401(k) that accepts IRA rollovers, there may be a solution to the dilemma.  The client may

  1. roll the pre-tax IRA contributions and earnings into the employer plan, leaving only after-tax money in the IRA, and then
  1. perform the Roth conversion.

When an IRA is rolled over to a pension plan, the rules provide that only the pre-tax money can be moved.  In fact, employer plans are not allowed to accept rollovers of after-tax contributions at all.  There are special rules that say rollovers of IRAs to pension plans drain the pre-tax part of the IRA first.  Rolling over that portion effectively strips out all the untaxed money and puts it in the pension plan, leaving only after-tax money in the traditional IRA.

On the subsequent Roth conversion, only after-tax money is converted from the traditional IRA.  While all the client’s IRAs must be aggregated for purposes of determining the taxable and non-taxable portion of the conversion, employer-sponsored retirement plans are not included in the aggregation.

For clients lucky enough to have employer plan accounts that accept rollovers, it’s possible to roll all the pre-tax contributions and earnings from an IRA into the employer plan, leaving only after-tax contributions in the IRA, and then accomplish a tax-free conversion to a Roth IRA.

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 31

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Here’s the question of the day.

Question: My 40 year old client is applying to take a hardship withdrawal from her 401K plan.  Is the distribution subject to the 10% penalty tax?

Answer: Yes, the taxable part of a 401K plan distribution is subject to the penalty tax unless one of the exceptions applies.  Here are the most common exceptions:

  • Death of the participant
  • Disability of the participant
  • Part of a series of substantially equal payments based on life expectancy
  • Taken by a participant who retired from the employer sponsoring the plan at age 55 or later
  • Distribution was used to pay for certain limited costs for medical care

Note that the 401K penalty tax exceptions do not include provisions for first time homebuyer or education expenses.

Hardship withdrawals may be made from a 401(k) plan only for an immediate and heavy financial need.  Financial need is not an exception to the 10% penalty tax.

If the client needs money, and is worried about the income tax consequences of a hardship withdrawal, a loan may be a better option if the plan permits it.  Loans are not considered taxable distributions at all.  However, if the plan permits a loan

  • The loan must be real and documented,
  • The maximum amount of the loan is the lesser of half the vested portion of the account or $50,000, and
  • The loan must be repaid under a regular amortization schedule not to exceed five years.

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.