Life Insurance and Annuities
Domain 1 tests whether you can trace dollars through a contract: premium in, cash value accumulating, death benefit or annuity payout out. Expect questions on policy structure, ownership rights, taxation of proceeds, and annuity payout mechanics.
Contract fundamentals
- Four roles are distinct: owner (holds all rights - surrender, loan, beneficiary change), insured (the life measured), payor, and beneficiary. A third-party owner creates a gift and an incidents-of-ownership question.
- Death proceeds are generally income-tax-free under IRC 101(a); interest paid on a settlement option is taxable to the recipient.
- A 1035 exchange moves life-to-life, life-to-annuity, or annuity-to-annuity tax-free. Annuity-to-life is not permitted.
Policy types and options
- Term is pure protection, renewable and/or convertible, with no cash value.
- Whole life offers guaranteed premium and cash value; dividends are not guaranteed and are tax-free only to the extent of basis.
- Universal life is flexible-premium with cost of insurance based on attained age; variable products place cash value in a separate account, shifting investment risk to the owner.
- Nonforfeiture options: cash surrender, reduced paid-up, extended term. Settlement options: lump sum, life income, fixed period, fixed amount, interest only.
Annuity taxation
Nonqualified annuity withdrawals are taxed LIFO - gain comes out first and is ordinary income, plus a 10% penalty before age 59½. Once annuitized, the exclusion ratio separates return of basis from taxable income.
Worked example
A 65-year-old pays $100,000 for a single premium immediate annuity with an expected return of $200,000, receiving $12,000 a year. Exclusion ratio = $100,000 ÷ $200,000 = 50%. Each payment is $6,000 excluded and $6,000 taxable. After the full basis is recovered, payments become 100% ordinary income.
Traps that cost marks
Mixing up LIFO (withdrawals) with the exclusion ratio (annuitized payments); overlooking that over-funding a universal life creates a modified endowment contract, killing tax-free loans and adding a 10% penalty; forgetting that a transfer for value can forfeit the income-tax-free death benefit.