TAXATION OF LIFE INSURANCE & TAX STRATEGIES (Chapter 7)

Question 1

REVIEW

What is a family coverage rider?

Answer 1

• Rider for policyholders who have a spouse and children.
• They’re sold in units that cover all eligible family members. (Ex. a unit might provide coverage of $5,000 for the spouse and $1,000 for each child.)

Question 2

Life Insurance Terminology

Adjusted Cost Basis (ACB)

Answer 2

The amount of money invested.

Question 3

REVIEW

How do you calculate the Net Amount at Risk ?

Answer 3

Death Benefit – Investment Account Value

(ex. Pratik owns a UL policy with a death benefit of $500,000 and an account
value of $128,000. The current NAAR of his policy is $372,000, calculated as
($500,000 – $128,000).

Question 4

Life Insurance Terminology

Deemed Disposition

Answer 4

When the policyholder gives up all ownership rights to the policy, by selling or surrendering the policy.

Question 5

REVIEW

What are the differences in mortality deductions and expenses with UL policy and Whole Life?

Answer 5

• Mortality deductions and expenses
  are deducted from investment account in UL. Mortality deductions may be based on YRT or LCOI costing.
• Mortality deductions and expenses
  are taken from policy reserves in Whole Life.

Question 6

REVIEW

Life Expectancy

Answer 6

Average number of years that a person can expect to live from that age forward.

Question 7

Life Insurance Terminology

Cash Surrender Value (CSV)

Answer 7

The amount that the insurance company will pay to the policyholder if the policyholder surrenders the contract.

Question 8

REVIEW

What are THREE ADVANTAGES of term insurance?

Answer 8

1. Premiums are guaranteed over the term.
2. Renewable and convertible provisions can be used to extend coverage.
3. Term of coverage can be customized to meet a specific need.

Question 9

REVIEW

Simplify Limited Payment Whole Life

Answer 9

Non-forfeiture option that provides lifelong coverage, while only requiring premiums for a specified guaranteed period of time.

(e.g., Hamish bought a 25-pay life policy on his own life when he was 45 years old. He only has to pay premiums for 25 years, at which point he will be 70 years old. However, the coverage will continue be past age 70, right up until his death.)

Question 10

Chapter 7

What is Taxation of life insurance?

Answer 10

Using life insurance to manage taxes that may arise upon death or as a result of a deemed disposition.

Question 11

Name some common situations of a deemed disposition in a life insurance policy

Answer 11

• Policyholder surrenders all or a part of the policy;
• Policyholder withdraws cash from the policy;
• Policyholder takes out a policy loan;
• Participating policy pays out dividends;
• Policy becomes non-exempt;
• Policyholder absolutely assigns or transfers ownership of the policy to another party;
• Policyholder dies and is not the life insured, such that ownership of the policy is transferred to
  another party.

Question 12

What is a policy gain?

Answer 12

Disposition of all or a portion of his interest in a life insurance policy.

Question 13

What are the calculations for a policy gain?

Answer 13

Policy gain = proceeds of disposition – adjusted cost basis (ACB)

(e.g., Brian surrendered his whole life insurance policy and received proceeds of $46,000. The insurance company advised him that his adjusted cost basis (ACB) was $20,000, so he had a policy gain of $26,000 and 100% of this was taxable. Policy gain = $46,000 – $20,000 = $26,000

Question 14

TRUE OR FALSE?

There are three ways to calculate a policy’s ACB, depending on when the policy was last acquired.

Answer 14

TRUE

Question 15

What is ”Last Acquired” ?

Answer 15

• Last acquired means the latest of the following dates:
• When the policy was first purchased;
• When ownership of the policy was transferred to the current policyholder;
• When coverage under the policy was last modified or reinstated.

Question 16

Life Insurance Terminology

Exempt vs Non-Exempt Policies

Answer 16

• Non-exempt policies are subject to annual accrual taxation.
• If an insurance policy is an exempt policy, the policy’s investment account can grow on a tax-deferred or tax-free basis.

Question 17

Life Insurance Terminology

Fair Market Value (FMV)

Answer 17

Fair market value (FMV) is an asset’s estimated value if it were sold today in the current market.

Question 18

Policies can be categorized in three groups for tax purposes, what are they?

Answer 18

• Group 1 (G1)
• Group 2 (G2)
• Group 3 (G3)

Question 19

Explain G1 Policies

Answer 19

Policies acquired prior to December 2, 1982 and that have not been transferred to another policyholder or been modified since that time.

Question 20

Explain G2 Policies

Answer 20

Policies acquired after December 1, 1982 but before January 1, 2017

Question 21

Explain G3 Policies

Answer 21

Group 3 (G3) policies are those that were issued after December 31, 2016, or previously G2 policies that have lost their status.

Question 22

TRUE OR FALSE?

A G1 policy will lose its status and become a G2 policy if ownership is transferred to another policyholder or if coverage is modified.

Answer 22

TRUE

G1 policies provide some significant tax
advantages, agents should be careful about changing this status.

Question 23

TRUE OR FALSE?

A G2 policy will lose its status and become a G3 policy if it is converted to another type of policy on or after December 2nd, 1982.

Answer 23

FALSE

• A G2 policy will lose its status and become a G3 policy if it is converted to another type of policy on or after January 1, 2017.

For example, a term policy that was issued in 2015 but that is converted
to a permanent policy in May 2022 will be a G3 policy from that point forward.

Question 24

TRUE OR FALSE?

A G2 policy can also lose its status and become a G3 policy if any coverage that requires medical underwriting is added to the policy after January 1, 2017

Answer 24

TRUE

Some examples include increasing the amount of coverage, adding a term rider to the policy, or substituting the life insured under the policy.

Question 25

G1 policies are sometimes referred to as?

Answer 25

Grandfather policies

Question 26

*TRUE OR FALSE?* The ACB calculated under the old method (G1 Policies) are usually lower than the ACB calculated under the methods for G2 or G3 policies

Answer 26

FALSE The ACB calculated under the old method (G1 Policies) will generally be **higher** than the ACB calculated under the methods for G2 or G3 policies. | [Ref. 7.1.4.2]

Question 27

*REVIEW* a policy gain is calculated as...

Answer 27

(Proceeds of disposition – ACB)

Question 28

*FILL IN THE BLANK* For G2 and G3 policies, the key factors that determine a policy’s ACB are ______________. a) YRT minus the NCPI b) NAAR minus the NCPI c) Death Benefit minus the NAAR d) Cumulative Premiums minus NCPI

Answer 28

For G2 and G3 policies, the key factors that determine a policy’s ACB are the **cumulative premiums less the net cost of pure insurance (NCPI)**

Question 29

*TRUE OR FALSE?* In the early years of a policy, (G2 & G3) the ACB of a policy decreases because the NCPI is **more** than the premiums.

Answer 29

FALSE In the early years of a policy, the ACB of a policy **increases** because the NCPI is **less** than the premiums. | [Ref. 7.1.4.3]

Question 30

# *Life Insurance Terminology* Net Cost of Pure Insurance (NCPI)

Answer 30

A measure of the pure mortality costs under the policy for a given year, and it reflects a combination of the net amount at risk (NAAR) and the mortality risk for the life insured.

Question 31

*TRUE OR FALSE?* When the life insured ages, his mortality risk **increases** to the point where the NCPI **exceeds the premiums** and the ACB of the policy decreases.

Answer 31

TRUE | [Ref. 7.1.4.3 ]

Question 32

Regulations to the Income Tax Act prescribe different methods of calculating both the NCPI and the NAAR for G2 and G3 policies. These regulations also prescribe the use of updated standardized mortality tables for G3 policies, reflecting increases in life expectancies. Name **one or two** of the general result of these changes:

Answer 32

- The NCPI of a G3 policy tends to be lower during the early years of the policy, compared to a G2 policy. - The ACB of a G3 policy will tend to grow faster in the early years of the policy, compared to a G2 policy. - It will take longer for the ACB of a G3 policy to reach zero as the life insured ages.

Question 33

Name **a couple** factors that affect the Policy's Adjusted Cost Basis

Answer 33

- Participating Policy Dividend - Policy Loans Repayments - Withdrawals and partial surrenders - Policy gains included in income

Question 34

# *G2 & G3 Policies* What is the calculation of Adjusted Cost Basis (ACB) for G2 & G3 policies?

Answer 34

Cumulative Premiums — NCPI = ACB

Question 35

| G2& G3 Policies *REVIEW* How do you calculate the **policy gain?**

Answer 35

Proceeds of disposition— ACB

Question 36

# *Adjusted Cost Basis Calculations* Last Acquired Polices (G1, G2, G3) (Participating & Non-Participating) **before & after** December 1st 1982 **key points**

Answer 36

**Policies prior to Dec. 2nd 1982 (G1)** *(Non-participating)* **CSV — Premium = ACB** *(Participating Policies)* **Premium — Dividends = ACB** ----------------------------------------------------------------   **Policies post Dec. 1st 1982 (G2 & G3)** *(Non-Participating)* **Premiums — NCPI = ACB** *(Participating)* **Premiums — NCPI — dividends = ACB**

Question 37

**Explain** *Taxation of a full surrender?*

Answer 37

- When the policyholder surrenders (cancels or terminates) the policy. - A full surrender is considered to be a disposition for tax purposes. -

Question 38

# *Life Insurance Terminology* MTR

Answer 38

Marginal Tax Rate

Question 39

# *Life Insurance Terminology* The difference between **Death Benefit & Face Amount**

Answer 39

- The face amount is the amount of money the insurance company agreed by contract to pay to beneficiaries after an insured person dies. - The death benefit amount includes the face amount, but it also includes add-ons, often called riders, that the policyholder included in the original contract.

Question 40

# *Life Insurance Terminology* Prorated

Answer 40

Divided, distributed, or assessed proportionately *(as to reflect an amount that is less than the full amount included in an initial arrangement)*

Question 41

What are the **calculations** of a full surrender?

Answer 41

**CSV — ACB = Policy Gain** *($24,00 - $10,00 = $14,000)* **Policy Gain x MTR = Tax Payable** *(14,000 x 35% = $4,900)* **CSV — MTR = After Tax Funds** *$24,000 — $4,900 = $19,000* | [Ref.7.3.1]

Question 42

What are the **calculations** for a *PARTIAL* surrender?

Answer 42

CSV = $24,000 ACB = $10,000 FA = $200,000 (Reducing $200,000 to $150,00 for example) 1. **Face Amount — Reduced Coverage / Face amount = Percentage%** *($200,000 — $150,000 / $200,000 = 25%)* 2. **Percentage% x ACB = Prorated ACB** *(25% x $10,000 = $2,500)* 3. **Percentage% x CSV = Prorated CSV** *(25% x $24,000 = $6,000)* 4. **Prorated CSV — Prorated ACB = Policy Gain** *($6,000 — $2,500 = $3,500)* 5. **Policy Gain x MTR = Tax Payment** *($3,500 x 35% = $1,225)* 6. **Policy Gain — Tax Payment = After Tax Gain** *($3,500 — $1225 = $2,275)* | [Ref.7.4.1]

Question 43

# Reducing Coverage *TRUE OR FALSE?* For G2 policies, the policy gain on a partial surrender is calculated on a **prorated basis**

Answer 43

TRUE For G2 policies, the policy gain on a partial surrender is calculated on a **prorated basis**, so the CSV and ACB used **reflect the reduction** in the coverage. | [Ref.7.4.1]

Question 44

# *Reducing Coverage* *TRUE OR FALSE?* For a G3 policy, the policy gain is also calculated on a prorated basis, **but** in this case the prorating is based on the ratio of the ACB of the policy to the policy’s **net** cash value

Answer 44

TRUE For a G3 policy, the policy gain is also calculated on a prorated basis, **but** in this case the prorating is based on the ratio of the ACB of the policy to the policy’s **net** cash value *(i.e., the **CSV minus outstanding policy loans**).

Question 45

# *Reducing Coverage* *TRUE OR FALSE?* For G1 policies, prorating **is** required.

Answer 45

FALSE For G1 policies, **no prorating** is required. Withdrawals only result in a policy gain once cumulative withdrawals exceed the entire policy’s ACB.

Question 46

What is a policy withdrawal?

Answer 46

- The withdrawal that the policyholder makes from the accumulating fund of a UL policy, even if he does not reduce the coverage - A policy withdrawal is also known as a partial surrender

Question 47

What are the **calculations** for a policy withdrawal?

Answer 47

FA = $200,000 ACB = $65,000 CSV = $80,000 1. **Amount withdrawn / CSV x ACB = Prorated ACB** *(($40,000 / $80,000) x $6500) = $32,500* 2. **Amount withdrawn — Prorated ACB = Policy Gain** *$40,000 —32,500 = $7500* 3. **Policy Gain x MTR = Tax Payable** *$7,500 x 35% = $2,625* 4. **Policy Gain — Tax Payable = After Tax Funds** *$7,500 — $2,625 = $2875* | [Ref. 7.4.2]

Question 48

*TRUE OR FALSE?* If the policyholder takes out a policy loan that is **less** than the adjusted cost basis (ACB), he will **not** have a policy gain, **but** the ACB will be **reduced** by the amount of the loan.

Answer 48

TRUE If the policyholder takes out a policy loan that is **less** than the adjusted cost basis (ACB), he will **not** have a policy gain, **but** the ACB will be **reduced** by the amount of the loan. - (e.g., If Alicia only took out a policy loan of **$4,000**, the policy’s ACB would be **reduced** to $6,000. New ACB = $10,000 – $4,000 = $6,000 She would not have to report a policy gain)

Question 49

What happens when the policyholder takes out a policy loan that is **greater** than the policy’s ACB?

Answer 49

If a policyholder takes out a policy loan that is **greater** than the policy’s ACB, he will have a policy gain equal to the amount of the loan, minus the ACB. The ACB of the policy will be reduced to zero. - (e.g., Alicia's ACB is $10,000. Suppose that she instead takes out a policy loan of $19,000. She would have a policy gain of $9,000 and $3,150 in tax payable. Policy gain = $19,000 – $10,000 = $9,000 Tax payable = $9,000 × 35% Her policy would now have an ACB of $0.

Question 50

What happens when you **repay** a policy loan?

Answer 50

If a policyholder repays a policy loan, he will be able to **deduct** the repayment from his taxable income, up to the amount of the policy gain he had to report when he took out the loan. If he repays **more** than this amount, the excess will **increase** the policy’s ACB. (e.g., Suppose that Alicia repays **$12,000** of her $19,000 policy loan. She would be able to claim a **tax deduction** of $9,000, **which is the amount of the policy gain she had to include in her income as a result of the loan.** The ACB of her policy would increase to $3,000. ACB calculated as ($12,000 – $9,000)).

Question 51

Does the policy loan have interest?

Answer 51

YES - When a policyholder takes out a policy loan, the insurance company will charge interest on that loan. - If the policyholder invests the loan proceeds for the purpose of earning property or business income, then he can **deduct** the interest he pays on that loan from his taxable income.

Question 52

What is an *exempt* life insurance policy?

Answer 52

Permanent insurance policy primarily for insurance purposes, rather than investment purposes.

Question 53

**Explain** Maximum Tax Actuarial Reserve (MTAR) rule

Answer 53

Hypothetical policy that serves as a benchmark to **project** the cash value of the accumulating fund of an exempt test policy. The projected future values of the accumulating fund **cannot** exceed the projected MTAR at any time in the future.

Question 54

What is an **exempt test**, and it's purpose?

Answer 54

Hypothetical rule that prevent taxpayers from taking unfair advantage of the favorable tax treatment of investment income that may be provided within an insurance policy.

Question 55

What are the *two* exempt test rules?

Answer 55

- Maximum Tax Actuarial Reserve (MTAR) rule - Anti-dump-in (250% Rule)

Question 56

*TRUE OR FALSE?* G1 policies are subject to the exempt test and annual accrual taxation.

Answer 56

FALSE G1 policies are **not** subject to the exempt test and are **not** subject to annual accrual taxation. | [Ref. 7.6.1]

Question 57

**Explain** the *concept* of the Maximum Tax Actuarial Reserve (MTAR) rule

Answer 57

- To maintain exempt status. - The cash value of a policy’s accumulating fund account **cannot exceed** the Maximum Tax Actuarial Reserve (MTAR), which is the **projected cash value of the accumulating fund of an exempt test policy**.

Question 58

*FILL IN THE BLANK* If the policy fails the MTAR test on its anniversary, the Income Tax Act allows a grace period of _______ after that date for the problem to be fixed before the policy officially loses its exempt status. a) 30 days b) 60 days c) 90 days d) 45 days

Answer 58

If the policy fails the MTAR test on its anniversary, the Income Tax Act allows a grace period of **60 days** after that date for the problem to be fixed before the policy officially loses its exempt status.

Question 59

*TRUE OR FALSE?* Once an exempt policy is declared to be non-exempt (i.e., if it cannot be restored during the 60-day grace period), it **remains non-exempt** forever.

Answer 59

TRUE

Question 60

What are the **remedies** for a policy to remain its exempt status?

Answer 60

- Increasing the face amount - Withdrawing premiums - Side funds (Side account) - Anti-dump in rule

Question 61

What's *Anti-dump in* rule?

Answer 61

It’s also known as the 250% rule which **prevents the policyholder from making large lump-sum deposits** to the policy after its 7th anniversary.

Question 62

How does the *Anti-dump in rule* apply?

Answer 62

- Beginning on the policy’s **10th anniversary** and every anniversary thereafter, the **accumulating fund on that anniversary** date is *compared* to the **accumulating fund three years previous**. - The **cash value** on the **10th anniversary** is *compared* to the cash value on the **7th anniversary**; the cash value on the 11th anniversary is compared to the cash value on the 8th anniversary, and so on. - If the value of the fund is **250% or more** of the value of the fund **three years prior**, the anti-dump-in provision **will** apply.