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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).