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1. How is a lump-sum life insurance death benefit paid to a named individual beneficiary treated for federal income tax purposes?

IRC §101(a) excludes amounts paid by reason of the insured's death from the beneficiary's gross income. Interest credited after the date of death on installment payouts is the only piece that becomes taxable.

2. What test determines whether a permanent life insurance policy is classified as a Modified Endowment Contract (MEC)?

Under IRC §7702A, a contract becomes a MEC if cumulative premiums paid in any of the first seven contract years exceed the seven-pay premium limit. The corridor and CVAT/GPT tests instead determine whether a contract qualifies as life insurance under §7702.

3. How is a partial withdrawal from a non-MEC permanent life insurance policy taxed?

IRC §72(e)(5) gives non-MEC life insurance FIFO ordering: the owner first recovers premiums paid (basis) tax-free, and only amounts above basis are taxed as ordinary income. MEC contracts use the opposite LIFO ordering.

4. An owner age 50 takes a $10,000 distribution from a Modified Endowment Contract that has $4,000 of gain over basis. What federal tax result generally applies?

MEC distributions follow LIFO, so the first $4,000 (the gain) comes out as ordinary income while the remaining $6,000 is a tax-free return of basis. Because the owner is under 59½, IRC §72(v) imposes an additional 10% tax on the $4,000 taxable portion.

5. Which of the following transactions is NOT permitted as a tax-free exchange under IRC §1035?

Section 1035 permits life-to-life, life-to-annuity, annuity-to-annuity, and (since the PPA of 2006) either contract into qualified LTC. Annuity-to-life is the one direction that is NOT allowed, because it would convert tax-deferred annuity gain into income-tax-free death proceeds.

6. How is a non-annuitized withdrawal from a non-qualified deferred annuity issued after August 13, 1982 taxed?

IRC §72(e)(2) applies LIFO treatment to post-1982 deferred annuity withdrawals: gain comes out first as ordinary income, and only after the gain is exhausted does the owner recover basis tax-free. Annuitized payments use the §72(b) exclusion ratio instead.

7. Under IRC §79, how much employer-paid group term life insurance coverage may an employee receive each year without imputed income?

IRC §79 excludes the cost of the first $50,000 of employer-paid group term life coverage from the employee's gross income. The cost of coverage above $50,000 is imputed to the employee using IRS Table I rates.

8. An employer pays 100% of the premium for an employee's group long-term disability insurance and does not include the premium in the employee's wages. If the employee later becomes disabled and receives monthly benefits, how are those benefits taxed?

Under IRC §105(a), when the employer pays the disability premium tax-free to the employee, the benefits the employee later receives are fully includible in gross income. The employee-pay rule under §104(a)(3) (tax-free benefits) only applies when the employee funds the premium with after-tax dollars.

9. When a non-qualified annuity contract is annuitized, the exclusion ratio is used to:

Under IRC §72(b), the exclusion ratio divides each annuity payment into a non-taxable return of the owner's investment in the contract and a taxable interest component. Once the owner has recovered the full investment, subsequent payments become entirely taxable.

10. Which of the following BEST keeps a life insurance death benefit out of the insured's federal gross estate?

Under IRC §2042 the death proceeds are included in the insured's gross estate whenever the insured holds any incidents of ownership. Transferring ownership to an ILIT (and avoiding the §2035 three-year look-back) is the standard estate-planning technique to remove the policy from the gross estate. Naming a spouse defers but does not avoid estate inclusion; how premiums are paid does not change §2042 inclusion.

11. Which statement BEST describes the federal tax treatment of a Health Savings Account (HSA)?

An HSA under IRC §223 provides the well-known triple tax advantage: deductible (or pre-tax) contributions, tax-deferred growth inside the account, and tax-free distributions when used for qualified medical expenses. Non-qualified withdrawals are taxable as ordinary income plus a 20% penalty if taken before age 65.

12. An investor purchases an existing $500,000 life insurance policy from the original owner for $40,000 and continues to pay $5,000 in annual premiums until the insured dies five years later. The investor is NOT one of the exempt transferees listed in §101(a)(2). How much of the $500,000 death benefit is taxable to the investor as ordinary income?

The transfer-for-value rule under IRC §101(a)(2) taints the §101(a) exclusion when a policy is transferred for valuable consideration to a non-exempt party. The new owner's basis is the consideration paid plus subsequent premiums ($40,000 + $25,000 = $65,000). The death benefit above that basis ($500,000 − $65,000 = $435,000) is ordinary income.

13. While a non-MEC life insurance policy remains in force, how is an outstanding policy loan treated for federal income tax purposes?

A loan from a non-MEC life insurance policy is not a distribution and is not taxable while the contract stays in force. If the policy lapses or is surrendered with the loan outstanding, the unpaid loan is treated as a deemed distribution and any gain above the owner's basis becomes ordinary income.

14. How are benefits paid from a tax-qualified long-term care insurance contract generally treated for federal income tax?

Under IRC §7702B, benefits from a tax-qualified LTC policy are excluded from gross income up to the indexed per-diem limit (set annually by the IRS) or the actual cost of qualified LTC services, whichever is greater. Reimbursement-style benefits paid for actual expenses are fully excluded; per-diem benefits are excluded up to the daily cap.

15. Which statement about the federal tax treatment of a Modified Endowment Contract (MEC) is TRUE?

The MEC label under IRC §7702A changes the lifetime tax treatment only. Distributions during the insured's life are taxed LIFO (gain first as ordinary income), with a 10% additional tax under §72(v) if taken before age 59½. The death benefit paid because of the insured's death remains excluded from the beneficiary's gross income under §101(a).

16. A policyowner wants to exchange a $50,000 cash-value whole life policy for a non-qualified deferred annuity. Which statement about the tax treatment is correct?

Under IRC §1035, a policyowner can exchange a life insurance policy for an annuity (or annuity-to-annuity, or life-to-life) without recognizing the gain at the time of exchange, provided the contracts are owned by the same person and the transfer goes directly from one insurer to another (a '1035 exchange'). Cost basis carries over to the new contract. Option A would apply only if the policyowner SURRENDERED the policy and used the proceeds to buy the annuity (a constructive receipt) — not a §1035 direct transfer. Option C is reversed — a life policy CAN exchange to an annuity (one-way only; you cannot exchange an annuity back to a life policy). Option D conflates the §72(q) 10% penalty, which applies to taxable annuity withdrawals before 59½, not to a properly executed §1035 exchange.

17. A whole life policy fails the 7-pay test and is classified as a Modified Endowment Contract (MEC). Which statement BEST describes the tax consequence to the policyowner?

A Modified Endowment Contract under IRC §7702A is still a life insurance contract — the death benefit remains income-tax-free to the beneficiary under IRC §101(a). However, all living distributions (policy loans, partial withdrawals, collateral assignments) are taxed on a LIFO (last-in, first-out) basis: gain comes out first as ordinary income, and a 10% additional tax applies before age 59½ under IRC §72(v). Option A is incorrect — the death benefit retains its income-tax-free treatment. Option B is wrong — life insurance premiums are never deductible by an individual policyowner. Option D conflates §7702A (MEC rules) with §7702 (definition of life insurance) — a MEC remains life insurance for §7702 purposes; only the living-benefit taxation changes.

18. A small business pays the premium on a $250,000 group term life policy on a key executive. The business is the policyowner and primary beneficiary. Which statement about premium deductibility is correct?

Under IRC §264(a)(1) and Treasury Regulation §1.264-1, no income-tax deduction is allowed for premiums on a life insurance contract when the taxpayer paying the premium is directly or indirectly a beneficiary. Because the business here is both policyowner and beneficiary (a key-person policy), the premium is non-deductible — but in exchange the death benefit is generally received income-tax-free under IRC §101. Option B confuses this with employer-paid group term where the EMPLOYEE is the insured AND the beneficiary is the employee's family (then deductible). Option C describes the EMPLOYEE's §79 $50,000 exclusion from imputed income, not employer deductibility. Option D is fabricated — convertibility has no impact on deductibility.

19. Ana paid $30,000 in premiums on a non-MEC whole life policy. She surrenders the policy for $48,000 in cash. How is the surrender taxed?

Under IRC §72(e), a surrender of a non-MEC life insurance policy uses cost-recovery treatment: the policyowner first recovers her cost basis (total premiums paid, less prior dividends taken in cash and less any nontaxable distributions), and only the excess over basis is taxable. Here basis is $30,000 and cash received is $48,000, so $18,000 is taxable. That gain is taxed as ORDINARY INCOME (option C is wrong — life insurance inside-buildup is never capital gain). Option A ignores basis recovery. Option D ignores the $18,000 gain. This is the standard 'cost-recovery first' rule that distinguishes non-MEC life insurance from MECs (which are taxed LIFO/gain-first under §72(e)(10)).

20. Which statement BEST distinguishes a qualified retirement plan (such as a 401(k)) from a non-qualified deferred annuity for federal income tax purposes?

A qualified plan under IRC §401(a), §401(k), §403(b), or §457 receives 'front-end' tax favor: contributions go in pre-tax (deductible or excluded from W-2 income), grow tax-deferred, and are taxed in full on distribution because no basis was created. A non-qualified annuity is funded with AFTER-TAX dollars — contributions are not deductible — but earnings grow tax-deferred, and only the gain portion of distributions is taxed (cost-recovery via the exclusion ratio at annuitization, or LIFO for non-annuitized withdrawals under §72(e)). Option A is wrong — non-qualified annuity premiums are never deductible. Option B is wrong — qualified plans require RMDs at age 73 under §401(a)(9). Option C is reversed — qualified withdrawals are taxable, not tax-free.

21. A corporation purchased an employer-owned life insurance (EOLI) policy on a rank-and-file employee in 2019 but did NOT obtain written notice or consent from the employee before issuance. The employee dies. How is the death benefit taxed to the corporation?

Under IRC §101(j), enacted by the Pension Protection Act of 2006, employer-owned life insurance issued after August 17, 2006 is subject to special rules. To preserve the full income-tax exclusion of the death benefit, the employer must (1) provide written notice to the employee of the insurance and the maximum face amount, (2) obtain written consent before issuance, and (3) meet one of the §101(j)(2) exceptions (e.g., insured was a director or highly compensated employee, or died within 12 months of separation). If these 'notice and consent' rules are NOT met, only the amount equal to premiums paid is tax-free — the gain (death benefit minus premiums) is taxable as ordinary income. Option A ignores §101(j). Option B confiscates basis. Option D applies to employee-level §79 imputed-income exclusion, not corporate death benefits.

22. A corporation owns a $1,000,000 key-person life policy on its CEO. The corporation transfers the policy to an unrelated third party for $40,000 cash. The CEO subsequently dies and the third-party owner collects $1,000,000. How is the death benefit taxed to the third-party owner?

Under IRC §101(a)(1), life insurance death benefits are generally received income-tax-free by the beneficiary. However, IRC §101(a)(2) — the TRANSFER-FOR-VALUE rule — carves out an exception: when a life policy is transferred FOR VALUABLE CONSIDERATION, the income-tax exclusion is largely lost. The transferee may exclude only an amount equal to the consideration paid plus any subsequent premiums; the excess death benefit is taxable as ordinary income. Five SAFE-HARBOR exceptions preserve the full exclusion: transfer to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is an officer or shareholder, or a transfer with a carryover basis (e.g., gift). Here, the unrelated third-party buyer fits no exception, so the §101(a)(2) rule applies. Options A, B, and D misstate the rule.

23. An employee receives $200,000 of EMPLOYER-PAID group term life insurance through a non-discriminatory cafeteria plan. Under IRC §79, the income-tax treatment is:

Under IRC §79, the cost of EMPLOYER-PROVIDED group term life insurance is excluded from the employee's gross income only up to the FIRST $50,000 of coverage. For coverage in excess of $50,000, the IRS calculates the cost using Uniform Premium Table I (an age-based monthly rate per $1,000 of excess coverage), reduces it by any after-tax employee contributions, and adds the net amount to the employee's W-2 wages as IMPUTED INCOME (subject to income tax and FICA but generally not federal unemployment tax). For a $200,000 policy, $150,000 of excess coverage generates imputed income each year based on the employee's age. Option A overstates by taxing the face amount itself. Option B ignores the $50,000 cap. Option C is reversed. This is one of the most frequently tested taxation rules.

24. Which statement is correct regarding ROTH IRA distributions in 2026?

A ROTH IRA under IRC §408A is funded with AFTER-TAX dollars (no current deduction) and offers tax-free 'qualified' distributions if two conditions are met: (1) the 5-TAXABLE-YEAR holding period beginning with the first Roth contribution (or conversion) has been satisfied AND (2) the distribution is made on or after the owner reaches age 59½, the owner's death, the owner's disability, or for a first-time-homebuyer purchase (up to a $10,000 lifetime cap). Qualified distributions are entirely income-tax-free and exempt from the 10% early-distribution penalty. Original ROTH IRAs are NOT subject to lifetime required minimum distributions (RMDs) for the owner. Option A is wrong; Roth contributions are not deductible. Option C ignores the qualified-distribution rules. Option D is wrong; SECURE 2.0 confirmed that Roth IRA owners face no lifetime RMDs (though beneficiaries do).