Retirement and Other Life Insurance Concepts — practice questions

5% of the exam ≈8 real questions 11 free questions here

Qualified and nonqualified plans, group life, business insurance, life settlements, and tax treatment — about 8 scored questions. Small domain, heavy on tax rules that are easy points once memorized.

Where people lose points

• Death benefits are income-tax-free; cash value gains taken during life are not.
• A MEC changes lifetime distributions to LIFO with a 10% penalty before 59½ — the death benefit stays tax-free.
• Group life conversion is a 31-day window and does not require evidence of insurability.
• Key person insurance protects the business; buy-sell funds a transfer of ownership.

Questions and answers, explained

All 8 questions above, with the correct answer and why it is correct. Everything here is on retirement and other life insurance concepts.

1. A cash value life insurance policy becomes a modified endowment contract (MEC) when:

   • AIts cash value at any point during the contract exceeds the policy’s stated death benefit
   • BThe policy is exchanged under Section 1035 within seven years of its original issue date
   • CThe owner takes a policy loan against the cash value during the first seven years
   • DPremiums in the first seven years exceed the seven-pay net level premium limitCorrect

   Why: The seven-pay test compares cumulative premiums actually paid in each of the first seven contract years against the seven-pay net level premium; exceeding it at any point makes the contract a MEC. Choice C reverses cause and effect — a loan does not create MEC status, but a loan taken from a contract that is already a MEC is a taxable distribution. Outline IV — taxation of life insurance.

   Reference Outline IV — MEC and the seven-pay test (IRC s. 7702A)

2. Which of the following exchanges will NOT qualify for tax-free treatment under Section 1035?

   • AA life insurance policy exchanged for an annuity
   • BAn annuity exchanged for another annuity
   • CAn annuity exchanged for a life insurance policyCorrect
   • DA life insurance policy exchanged for a qualified long-term care contract

   Why: Section 1035 allows exchanges in one direction only: life to life, life to annuity, annuity to annuity, and life or annuity to a qualified long-term care contract. An annuity may never be exchanged into life insurance, because that would convert taxable annuity gain into a tax-free death benefit. Choices B and D are both expressly permitted. Outline IV.

   Reference Outline IV — Section 1035 exchanges

3. An employer pays the entire premium for $200,000 of group term life insurance on a 52-year-old employee. What amount of coverage generates imputed income, and how is the cost measured?

   • A$150,000, measured by the IRS Table I uniform premium rate for the employee's ageCorrect
   • B$200,000, measured by the employer's actual premium outlay
   • C$200,000, measured by the IRS Table I uniform premium rate
   • DNone; employer-paid group term life is fully excludable from income

   Why: IRC Section 79 excludes the first $50,000 of employer-provided group term life; the cost of the excess $150,000 is imputed to the employee using the IRS Table I uniform premium rates for his age bracket, not the employer's actual cost. Any premium the employee pays with after-tax dollars reduces the imputed amount. Choice D forgets the $50,000 ceiling on the exclusion. Outline IV.

   Reference Outline IV — IRC s. 79 group term life imputed income

4. A corporation buys a $1,000,000 key person policy on an executive but never gives her written notice or obtains her written consent before the policy is issued. She dies eight years later, after the company has paid $120,000 in premiums. What is the tax result to the corporation?

   • AThe full $1,000,000 is received income-tax-free
   • BNothing is taxable, but the premiums paid become retroactively deductible
   • CThe entire $1,000,000 is taxable income to the corporation
   • DThe $880,000 received in excess of premiums paid is taxable income to the corporationCorrect

   Why: Under the employer-owned life insurance rules of IRC s. 101(j), death proceeds are income-tax-free only if the employer gave written notice and obtained the insured's written consent before the contract was issued; without that, the employer recovers only its premiums tax-free and the excess is taxable income. Choice B is wrong on a separate and permanent rule: key person premiums are never deductible, because the employer is the beneficiary. Outline IV.

   Reference Outline IV — Key person insurance; IRC s. 101(j) notice and consent

5. A 70-year-old who is neither terminally nor chronically ill sells his $500,000 policy in a life settlement for $130,000. He has paid $70,000 in premiums, and the policy's cash surrender value is $95,000. How is his $60,000 gain taxed?

   • AAll $60,000 is long-term capital gain
   • BAll $60,000 is ordinary income
   • C$25,000 is ordinary income and $35,000 is long-term capital gainCorrect
   • DNothing is taxable, because life insurance proceeds are excluded from income

   Why: Life settlement proceeds are taxed in three tiers: tax-free up to the $70,000 basis; ordinary income from basis up to the $95,000 cash surrender value, which is $25,000 of inside build-up; and long-term capital gain on the $35,000 above cash surrender value. Since the 2017 tax law, basis is total premiums paid with no reduction for the cost of insurance, so answers that give the whole $60,000 a single tax character (A or B) misapply the tiers. Outline IV.

   Reference Outline IV — Life settlement taxation (three-tier rule after the 2017 tax law)

6. Which of the following is a characteristic of a qualified retirement plan?

   • AEmployer contributions are tax-deductible when made, and plan earnings grow tax-deferredCorrect
   • BThe plan may discriminate in favor of highly compensated executives
   • CThe plan does not need to meet IRS requirements or receive IRS approval
   • DDistributions at retirement are always received income-tax-free

   Why: A qualified plan meets IRS requirements in exchange for tax advantages: the employer deducts contributions when made, and earnings accumulate tax-deferred until distributed. Qualified plans must not discriminate in favor of highly compensated employees — the ability to discriminate is the hallmark of nonqualified plans such as deferred compensation. Distributions of pre-tax contributions and earnings are taxed as ordinary income when received, so option D is also wrong. Outline IV.D (qualified vs. nonqualified plans).

   Reference Outline IV.D — Retirement plans: qualified vs. nonqualified

7. A fully insured worker dies, leaving a 40-year-old surviving spouse and a 14-year-old child. Social Security survivor benefits paid to the spouse for caring for the child will stop when the child turns 16 and will not resume until the spouse reaches age 60. This gap in benefits is known as the:

   • AThe elimination period
   • BThe probationary period
   • CThe blackout periodCorrect
   • DThe grace period

   Why: The blackout period is the span during which no Social Security survivor benefits are paid to the surviving spouse — it begins when the youngest child turns 16 and ends when the spouse qualifies for widow's or widower's benefits, as early as age 60. Life insurance needs analysis specifically targets this gap when calculating family income needs. The elimination period (the closest distractor) is the waiting period before disability benefits begin, a different concept. Outline IV.F (Social Security benefits).

   Reference Outline IV.F — Social Security benefits (blackout period)

8. Under the seven-pay test, a life insurance policy is classified as a modified endowment contract (MEC) when:

   • AThe policy is surrendered for its full cash value within seven years of the date it was issued.
   • BThe insured dies within seven years of the policy date shown on the contract.
   • CThe policyowner takes a policy loan at any time during the first seven years.
   • DCumulative premiums in the first seven years exceed the seven-pay net level premium limit.Correct

   Why: The seven-pay test measures funding speed: if cumulative premiums in any of the first seven years exceed the net level premiums that would have made the contract paid up in seven years, the policy is a MEC. Option C is the closest distractor because loans are where MEC status bites, but taking a loan is a consequence question, not the classification test. Surrender and death do not determine MEC status. (Outline IV.G; IRC s. 7702A.)

   Reference FL 2-15 Outline IV.G (Tax treatment: modified endowment contracts); IRC s. 7702A

Topics inside this domain

• Annuities on the Florida 2-15
• Buyer's Guide and Florida free look periods

Drill other domains

• Types of Life Policies and Features (10%)
• Life Policy Riders, Provisions, Options, and Exclusions (10%)
• Life Application, Underwriting, and Policy Delivery (8%)
• Types of Health Policies (11%)
• Health Policy Provisions, Clauses, and Riders (10%)
• Social Insurance (4%)

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