New Hampshire Life & Health Insurance Exam — All Questions

When a life insurance death benefit is paid to a named beneficiary as a lump sum, how is that benefit generally treated for federal income tax purposes?

• a.Only the portion equal to premiums paid is tax-free
• b.The entire amount is taxable as ordinary income
• c.The death benefit is generally received free of federal income tax✓
• d.It is taxed as a capital gain

Life insurance death proceeds paid to a beneficiary are generally received income-tax-free, one of the primary tax advantages of life insurance. It is therefore not taxed as ordinary income in full, nor limited to a return of premiums, nor treated as a capital gain. Note that if the death benefit is paid in installments, any interest earned on the retained proceeds is taxable, and the proceeds may still be part of the insured's estate for estate-tax purposes, but the core death benefit itself is income-tax-free.

In a nonqualified deferred annuity, how are withdrawals taxed during the accumulation phase under the standard tax rule?

• a.Earnings (interest) are considered withdrawn first and are taxable as ordinary income (LIFO)✓
• b.All withdrawals are entirely tax-free because the money was already taxed
• c.Withdrawals are taxed as long-term capital gains
• d.The principal (cost basis) comes out first and is taxable

For nonqualified annuities purchased after August 13, 1982, withdrawals follow last-in, first-out (LIFO) tax treatment: the taxable earnings (interest) are treated as coming out first and are taxed as ordinary income, and a 10% penalty may apply before age 59 1/2. The already-taxed principal (cost basis) comes out only after the earnings are exhausted, so the second option reverses the order. Annuity gains are ordinary income, not tax-free and not capital gains, which rules out the first and fourth options. During annuitization, the exclusion ratio instead spreads the return of basis across each payment.

Life insurance proceeds may be pulled into the insured's taxable estate for federal estate tax purposes if, at death, the insured held:

• a.No rights of any kind in the policy
• b.Only a role as the named beneficiary
• c.Any incidents of ownership in the policy✓
• d.A policy with a face amount under ten thousand dollars

If the insured retained any incidents of ownership (such as the right to change the beneficiary, borrow the cash value, or surrender the policy), the death benefit is generally includable in their gross estate. Holding no rights keeps the proceeds out of the estate, which is why irrevocable life insurance trusts are used. Merely being a beneficiary of someone else's policy is not an incident of ownership over one's own life coverage, and the face amount size does not control estate inclusion. Incidents of ownership are the key test.

The 'transfer-for-value' rule can cause a normally income-tax-free death benefit to become partly taxable when:

• a.An existing policy is sold or transferred to another party for valuable consideration✓
• b.The insured names a spouse as beneficiary
• c.The policy is simply kept and never transferred to anyone for money or other valuable consideration
• d.Premiums are paid on an annual schedule

Under the transfer-for-value rule, if an in-force policy is transferred to another party for valuable consideration, part of the death benefit (the amount exceeding the buyer's basis) can become taxable, unless an exception applies. Simply keeping a policy, paying annual premiums, or naming a spouse as beneficiary does not trigger the rule. The rule exists to prevent policies from being traded as tax-free investment vehicles, and producers must flag it whenever a policy changes hands for value.

A life insurance policy becomes a modified endowment contract (MEC) when it:

• a.Is issued as term insurance
• b.Pays annual dividends to the owner, which is a feature of participating whole life, not a MEC trigger
• c.Has a named contingent beneficiary
• d.Is funded more quickly than the limits allowed under the seven-pay test✓

A policy is classified as a MEC if the cumulative premiums paid in the early years exceed the limits set by the seven-pay test, meaning it was funded too fast relative to its death benefit. Being term insurance, paying dividends, or naming a contingent beneficiary does not create a MEC. The MEC rules were enacted to stop people from overfunding life insurance purely as a tax shelter, and once a policy is a MEC its living distributions lose favorable tax treatment.

Once a policy is classified as a modified endowment contract (MEC), distributions taken during the insured's life, such as loans and withdrawals, are:

• a.Always completely free of income tax
• b.Exempt from any penalty regardless of the owner's age, which is not true because an early-distribution penalty can still apply before age 59 1/2
• c.Taxed on a last-in, first-out basis, with earnings taxed first and a possible ten percent penalty before age 59 1/2✓
• d.Fully deductible from the owner's income

In a MEC, living distributions (including policy loans) are taxed LIFO, so the taxable earnings come out first as ordinary income, and a ten percent penalty may apply if taken before age 59 1/2, similar to annuity taxation. They are not tax-free, not deductible, and not penalty-exempt. Importantly, MEC status affects only living distributions; the death benefit paid to a beneficiary generally remains income-tax-free. This is why overfunding a policy into MEC status must be done knowingly.

A Section 1035 exchange allows a policyowner to:

• a.Deduct all future premiums from taxable income
• b.Withdraw the cash value tax-free forever
• c.Exchange one life or annuity contract for another like-kind contract without immediately recognizing taxable gain✓
• d.Avoid income tax on every future gain permanently, which overstates the benefit because the exchange only defers the tax rather than erasing it

A 1035 exchange lets an owner transfer the value of one contract into a new like-kind contract (for example, annuity to annuity, or life to annuity) without triggering tax on the gain at the time of exchange, allowing an upgrade to a better product while preserving cost basis. It does not make premiums deductible, does not create permanently tax-free withdrawals, and does not eliminate future tax on gains, which are simply deferred. The benefit is tax deferral, not tax elimination.

Which of the following is a permissible tax-free Section 1035 exchange?

• a.An annuity exchanged for a life insurance policy
• b.A life insurance policy exchanged for an annuity✓
• c.A Roth IRA exchanged for a personal automobile
• d.An annuity exchanged for shares in a mutual fund

A life insurance policy may be exchanged tax-free for an annuity under Section 1035, but the reverse (annuity to life insurance) is not permitted, because that would move gain into a contract whose death benefit is income-tax-free. Exchanging an annuity for a mutual fund is not a like-kind insurance exchange, and a Roth IRA for a car is not an exchange at all. Remember the one-way rule: life can become an annuity, but an annuity cannot become life insurance under 1035.

A loan taken against the cash value of a life insurance policy is generally:

• a.Fully taxable in the year it is taken
• b.Not taxable as long as the policy remains in force✓
• c.Deductible as interest by the borrower
• d.Subject to an automatic fifty percent penalty at the time it is taken

A policy loan is not treated as taxable income while the policy stays in force, because it is a loan against the owner's own cash value, not a distribution. It is not automatically taxable, the interest is generally not deductible for personal policies, and there is no fifty percent penalty. However, if the policy later lapses or is surrendered with a loan outstanding, the previously untaxed gain can become taxable, so unpaid loans carry a hidden tax risk (and this does not apply the same way to a MEC).

If a policyowner surrenders a whole life policy for its cash value, any amount received above the total premiums paid (the cost basis) is:

• a.Never required to be reported
• b.Taxable as ordinary income✓
• c.Taxed at long-term capital gains rates
• d.Always received completely tax-free

On surrender, the gain (cash value received minus the cost basis of premiums paid) is taxed as ordinary income, not as a capital gain. It is not tax-free, and it must be reported. The portion equal to the premiums paid is a tax-free return of basis. This is a common exam point: living gains from life insurance and annuities are ordinary income, never capital gains, even though the underlying growth felt like an investment return.

Dividends paid on a participating life insurance policy are generally treated for federal tax purposes as:

• a.A deductible expense for the policyowner
• b.Fully taxable ordinary income when received by the policyowner in the year the dividend is paid
• c.A nontaxable return of premium, unless total dividends received exceed the premiums paid✓
• d.Long-term capital gains

Policy dividends are considered a return of a portion of the premium the owner overpaid, so they are generally not taxable; only if cumulative dividends eventually exceed the total premiums paid would the excess become taxable. They are not automatically taxable income, not capital gains, and not deductible. Note that this differs from the interest a dividend earns if left to accumulate, which is taxable. The dividend itself is a nontaxable return of premium.

Premiums paid for a personal life insurance policy are generally:

• a.Fully deductible from taxable income
• b.Not tax-deductible✓
• c.Partly deductible each year
• d.Convertible into a tax credit

Premiums for personal life insurance are paid with after-tax dollars and are not deductible; the trade-off is that the death benefit is generally received income-tax-free. They are not fully or partly deductible, nor do they generate a tax credit. This nondeductibility is consistent across most personal insurance premiums and is the reason the eventual benefits enjoy favorable tax treatment. Certain business-related arrangements have their own specific rules, but the personal premium itself is not deductible.

For key-person life insurance that a business owns and is the beneficiary of, the federal tax treatment is generally that the:

• a.Premiums are not deductible by the business, but the death benefit is received income-tax-free✓
• b.Premiums are deductible, and the death benefit is tax-free, which is not the treatment key-person coverage receives
• c.Premiums generate a business tax credit
• d.Premiums are deductible, and the death benefit is taxable

With key-person insurance, the business cannot deduct the premiums because it is the beneficiary of a policy on a valuable employee, but in exchange the death benefit it receives is generally income-tax-free (subject to employer-owned life insurance notice and consent rules). The premiums are not deductible, so options describing deductible premiums are wrong, and there is no special tax credit. This mirrors the general principle that nondeductible premiums buy a tax-free benefit.

Under federal tax rules, employer-paid group term life insurance is income-tax-free to the employee on coverage up to:

• a.An unlimited amount of coverage
• b.Ten thousand dollars of coverage
• c.Two hundred fifty thousand dollars of coverage, which is far above the threshold at which employer-paid group term becomes taxable
• d.Fifty thousand dollars, with the cost of coverage above that amount taxable to the employee as imputed income✓

An employee may receive up to fifty thousand dollars of employer-paid group term life coverage without owing income tax on the premium; for coverage above fifty thousand dollars, the IRS-determined cost of the excess is added to the employee's taxable income as imputed income. The threshold is not ten thousand, two hundred fifty thousand, or unlimited. This fifty-thousand-dollar rule is a frequently tested figure in group life taxation.

In a cross-purchase buy-sell agreement funded with life insurance, the policies are owned by:

• a.The individual owners, each on the other owners' lives✓
• b.The business entity itself
• c.An outside bank or lender
• d.The estate of the deceased owner rather than by the surviving owners

In a cross-purchase arrangement, each business owner buys and owns a life insurance policy on each of the other owners, so that when one dies, the survivors receive proceeds to buy the deceased's share directly from the estate. The business entity does not own the policies (that is an entity or stock-redemption plan), a bank is not involved, and the deceased's estate does not own them. The distinction between cross-purchase and entity plans centers on who owns the policies.

In an entity (stock-redemption) buy-sell plan, the life insurance is owned by:

• a.The business's customers
• b.Each owner individually on the others, which is the cross-purchase arrangement instead
• c.The company's rank-and-file employees
• d.The business itself, which agrees to buy back a deceased owner's interest✓

In an entity or stock-redemption plan, the business owns the policies on each owner and uses the proceeds to purchase (redeem) the deceased owner's interest from the estate, keeping the buyout centralized in the company. The owners do not each hold policies on one another (that is the cross-purchase approach), and employees and customers are not parties to the funding. Entity plans are often simpler when there are many owners, since the business holds one policy per owner rather than many cross-owned policies.

An executive bonus (Section 162) plan generally works by having:

• a.All taxes deferred indefinitely for both parties
• b.The employer pay (bonus) the premium on a life policy the executive owns, deductible to the employer and taxable to the executive✓
• c.The employer lend money that must be repaid with interest
• d.The executive pay all costs out of pocket with no employer help, which is the opposite of how an employer-funded Section 162 bonus arrangement operates

In a Section 162 executive bonus plan, the employer pays the premium on a personally owned life insurance policy for a key executive; the employer deducts the bonus as compensation, and the executive reports it as taxable income but owns the policy and its cash value. The executive does not bear the full cost alone, it is a bonus rather than a loan, and taxes are not deferred, the bonus is currently taxable to the executive. Simplicity and employer deductibility make this a popular executive benefit.

Distributions from a traditional, fully pre-tax qualified retirement plan are:

• a.Taxed at long-term capital gains rates rather than as the ordinary income they actually are
• b.Taxed as ordinary income, and required minimum distributions eventually apply✓
• c.Partly deductible when received
• d.Always received free of income tax

Because contributions to a fully pre-tax qualified plan went in before tax and grew tax-deferred, the entire distribution is taxed as ordinary income when withdrawn, and required minimum distributions must begin at the age set by law. The distributions are not tax-free, not taxed as capital gains, and not deductible. This is also why placing a tax-deferred annuity inside a qualified plan is chosen for its income guarantees rather than for any added tax deferral, since the plan is already tax-deferred.

A ten percent federal tax penalty generally applies to taxable withdrawals from annuities and qualified plans taken before the owner reaches age:

• a.Seventy
• b.Sixty-five, the common retirement age
• c.Fifty
• d.Fifty-nine and one-half✓

The ten percent early-distribution penalty generally applies to taxable amounts withdrawn before age 59 1/2, on top of ordinary income tax, to discourage using retirement-oriented products for early spending. Ages 65, 70, and 50 are not the general threshold (65 is a common retirement/Medicare age, and required minimum distributions begin later). The 59 1/2 figure is one of the most frequently tested numbers in life and annuity taxation.

Accelerated death benefits paid to an insured who has been certified as terminally ill are generally:

• a.Received free of federal income tax✓
• b.Taxed at capital gains rates
• c.Deductible by the insured
• d.Fully taxable as ordinary income to the insured

Accelerated death benefits paid because an insured is terminally ill are generally treated like a tax-free death benefit and received income-tax-free, which lets the insured use the money for care without a tax burden. They are not fully taxable, not taxed as capital gains, and not deductible. This favorable treatment (subject to certain limits for chronically ill insureds) reflects the policy goal of helping seriously ill insureds access their benefits early.

A Section 1035 exchange permits a tax-free transfer between:

• a.Like insurance contracts, such as life-to-life, life-to-annuity, or annuity-to-annuity✓
• b.An annuity and a personal checking account
• c.A health policy and a pension plan
• d.A life insurance policy and an ordinary consumer car loan carried at the policyowner's own bank

Section 1035 allows tax-free exchanges among like contracts, letting a policyowner move to a better product without triggering tax on the gain. Transfers to unrelated financial accounts do not qualify.

Which 1035 exchange is NOT permitted on a tax-free basis?

• a.Life insurance to another life insurance policy
• b.Annuity to a life insurance policy✓
• c.Life insurance to an annuity
• d.Annuity to another annuity

You may exchange life to life, life to annuity, or annuity to annuity tax-free, but not an annuity into a life insurance policy, because that would move taxable gain into a tax-free death benefit. The permitted directions preserve the tax structure.

The main tax disadvantage of a Modified Endowment Contract (MEC) is that:

• a.The premiums the owner pays into the contract suddenly become fully tax-deductible on the owner's personal income tax return
• b.The death benefit becomes taxable
• c.Living distributions such as loans and withdrawals are taxed on a LIFO basis, with a possible 10% penalty before age 59 1/2✓
• d.It can no longer pay policy dividends

A MEC loses favorable living-benefit treatment: loans and withdrawals are taxed earnings-first (LIFO) and may carry a 10% penalty before 59 1/2. The death benefit itself remains income-tax-free.

The general rule that life insurance death proceeds are income-tax-free can be lost under the 'transfer-for-value' rule when the policy is:

• a.Never sold or transferred to any party, but is instead simply allowed to lapse for nonpayment of the premium
• b.Sold or transferred for valuable consideration to certain parties, making part of the proceeds taxable✓
• c.Paid up with annual premiums
• d.Owned by the insured's spouse

If a policy is transferred for value to a non-exempt party, the death benefit can become partly taxable, an exception to the usual income-tax-free rule. Simply keeping or paying up a policy does not trigger it.

When death proceeds are left with the insurer and paid to the beneficiary in installments, the portion that is taxable is the:

• a.Entire payment
• b.None of the payment
• c.Return of the principal death benefit
• d.Interest earned on the retained proceeds✓

The death benefit principal remains income-tax-free, but any interest the insurer credits on proceeds it holds under a settlement option is taxable. Only that interest, not the principal, is taxed.

Premiums paid for personal life insurance are:

• a.Deductible once coverage exceeds $50,000
• b.Deductible as a medical expense
• c.Fully tax-deductible each year
• d.Generally NOT tax-deductible✓

Personal life insurance premiums are paid with after-tax dollars and are not deductible, which is part of why the death benefit is received tax-free. There is no coverage-amount or medical-expense exception for personal policies.

The cash value inside a permanent life insurance policy grows:

• a.Taxable to the owner each year
• b.Tax-free forever, with no conditions
• c.As a capital gain reported annually
• d.Tax-deferred while the policy remains in force✓

Cash value accumulates tax-deferred as long as the policy stays in force; it is not taxed annually. Gains can become taxable if the policy is surrendered for more than its basis.

Life insurance proceeds may be pulled into the insured's taxable estate if, at death, the insured held:

• a.a term policy
• b.a fully paid-up policy
• c.incidents of ownership, such as the right to change the beneficiary or borrow against the policy✓
• d.a beneficiary designation only

If the insured retained incidents of ownership, control such as changing beneficiaries or borrowing, the proceeds are included in the taxable estate. The policy type alone (term or paid-up) does not decide this.

Required minimum distributions (RMDs) generally force the owner of a traditional qualified plan to begin taking taxable distributions:

• a.Never during the owner's lifetime
• b.At age 40, so that the government can begin collecting income tax on the deferred funds much earlier in life
• c.Only after the owner's death
• d.At a specified age set by law (such as 73), so the IRS eventually collects tax on the deferred funds✓

RMDs require withdrawals to begin at the age set by law (currently around 73) so the deferred, pre-tax funds are eventually taxed. They start during the owner's lifetime, not only at death.

Premiums a business pays for key person life insurance are:

• a.Fully tax-deductible to the business as an ordinary and necessary operating expense in every single year
• b.Always taxable income to the employee
• c.Deductible by the insured employee
• d.NOT tax-deductible, but the death benefit is generally received income-tax-free by the business✓

Key person premiums are not deductible because the business is the beneficiary, but the death benefit it later receives is generally income-tax-free. The premiums are not the employee's income or deduction.

In an executive bonus (Section 162) plan, the employer:

• a.Owns the life insurance policy outright and names itself as the beneficiary, while the executive simply agrees to be the insured person
• b.Pays a bonus, deductible to the employer and taxable to the executive, that the executive uses to pay premiums on a policy they own✓
• c.Provides no real benefit to the executive
• d.Cannot deduct any part of the arrangement

In a Section 162 executive bonus plan, the employer pays a deductible bonus (taxable to the executive) and the executive owns the policy and pays its premiums. The employer does not own the policy.

A split-dollar life insurance arrangement is:

• a.An agreement in which an employer and employee share the costs and benefits of a life policy, such as premiums, cash value, and death benefit✓
• b.A type of deferred annuity
• c.A term insurance rider that an employer attaches to the executive's personal life insurance policy in order to provide extra temporary death benefit at a low cost
• d.A government insurance program

Split-dollar is an arrangement between an employer and employee (or two parties) to split the premium costs and policy benefits of a life policy. It is not a government program, annuity, or rider.