Home / Study topics / Taxes, Retirement, and Business Uses

Taxes, Retirement, and Business Uses

Taxation of death benefits and cash values, MECs, IRAs and qualified plans, group term life, key person coverage, buy-sell agreements, and Social Security.

Study questions and answers

Try each question first, then tap to check your answer.

1. Life insurance death benefits paid in a lump sum to a named beneficiary are generally:

  1. Free of income tax
  2. Taxed as ordinary income
  3. Taxed as capital gains
  4. Subject to a 10% penalty
Show answer
A. Free of income tax
Lump-sum death benefits are generally income tax free. Interest paid under settlement options is taxable.

2. A life insurance policy that fails the seven-pay test becomes a:

  1. Lapsed policy
  2. Paid-up policy
  3. Modified endowment contract (MEC)
  4. Term policy
Show answer
C. Modified endowment contract (MEC)
A policy funded faster than the seven-pay limit allows becomes a MEC and loses some of its tax advantages.

3. Loans and withdrawals from a modified endowment contract are taxed:

  1. Tax free, like any policy loan
  2. Earnings first (LIFO) as ordinary income, plus a 10% penalty if taken before 59 1/2
  3. Basis first (FIFO), with no penalty
  4. As capital gains
Show answer
B. Earnings first (LIFO) as ordinary income, plus a 10% penalty if taken before 59 1/2
MEC distributions are taxed like annuity distributions: gains come out first and are taxable.

4. For employer-paid group term life insurance, employees have imputed taxable income on coverage above:

  1. $10,000
  2. $25,000
  3. $50,000
  4. $100,000
Show answer
C. $50,000
The cost of employer-paid group term coverage above $50,000 is taxable income to the employee.

5. In a key person life insurance arrangement:

  1. The employee owns the policy
  2. The employee's family is the beneficiary
  3. Premiums are tax deductible to the business
  4. The business owns the policy, pays the premiums, and is the beneficiary
Show answer
D. The business owns the policy, pays the premiums, and is the beneficiary
Key person coverage protects the business from losing a vital employee. Premiums are not deductible.

6. In a cross-purchase buy-sell agreement:

  1. The business buys one policy on each owner
  2. Each owner buys a policy on each of the other owners
  3. The employer and employee split premiums
  4. Only the key employee is insured
Show answer
B. Each owner buys a policy on each of the other owners
In a cross-purchase plan, the surviving owners use the proceeds to buy the deceased owner's share. In an entity plan, the business owns the policies.

7. Roth IRA contributions are made with after-tax dollars, and qualified distributions are:

  1. Tax free
  2. Taxed as ordinary income
  3. Partly taxable
  4. Subject to a 10% penalty
Show answer
A. Tax free
Qualified Roth distributions, including earnings, are tax free.

8. Cash value growth inside a permanent life insurance policy is:

  1. Taxed each year as ordinary income
  2. Taxed each year as capital gains
  3. Tax deferred, and taxed only on the gain over basis if the policy is surrendered
  4. Tax free in all cases
Show answer
C. Tax deferred, and taxed only on the gain over basis if the policy is surrendered
The cash value grows tax deferred. On surrender, the amount above the premiums paid (basis) is taxable.

9. Distributions from a traditional IRA funded with deductible contributions are:

  1. Taxed as capital gains
  2. Taxed as ordinary income
  3. Taxed only on the contributions
  4. Tax free
Show answer
B. Taxed as ordinary income
Because contributions were deducted, the entire distribution is taxable.

10. Under current federal law, required minimum distributions from traditional IRAs generally must begin at age:

  1. 70 1/2
  2. 59 1/2
  3. 65
  4. 73
Show answer
D. 73
SECURE 2.0 raised the RMD age to 73, and to 75 starting in 2033. Roth IRAs have no RMDs for the original owner.

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

  1. Employer contributions are deductible, and the plan cannot discriminate in favor of highly paid employees
  2. Contributions are taxed when made
  3. IRS approval is not required
  4. The employer can choose which employees participate
Show answer
A. Employer contributions are deductible, and the plan cannot discriminate in favor of highly paid employees
Qualified plans must meet ERISA and IRS requirements to receive tax advantages.

12. A 403(b) plan is available to employees of:

  1. For-profit corporations only
  2. Federal government agencies
  3. Public schools and 501(c)(3) nonprofit organizations
  4. Self-employed individuals only
Show answer
C. Public schools and 501(c)(3) nonprofit organizations
403(b) plans are also called tax-sheltered annuities.

13. A SEP plan:

  1. Is available only to large corporations
  2. Cannot be used by self-employed people
  3. Requires employee salary deferrals
  4. Allows an employer to make contributions to employees' individual IRAs
Show answer
D. Allows an employer to make contributions to employees' individual IRAs
SEPs are popular with small businesses and the self-employed because they are simple to set up.

14. A SIMPLE plan is available to employers with:

  1. Only one employee
  2. Union employees only
  3. 100 or fewer employees and no other retirement plan
  4. 500 or more employees
Show answer
C. 100 or fewer employees and no other retirement plan
SIMPLE plans can be set up as IRAs or 401(k)s.

15. Which statement describes a defined benefit plan?

  1. Contributions are fixed, but benefits vary
  2. It promises a specific benefit at retirement, and the employer bears the investment risk
  3. Benefits depend on the account balance
  4. The employee bears the investment risk
Show answer
B. It promises a specific benefit at retirement, and the employer bears the investment risk
In defined contribution plans, the contribution is set and the benefit depends on investment results.

16. Vesting refers to the employee's:

  1. Ownership right to employer contributions in a retirement plan
  2. Right to borrow from the plan
  3. Choice of investments
  4. Eligibility to join the plan
Show answer
A. Ownership right to employer contributions in a retirement plan
Employee contributions are always 100% vested.

17. To avoid taxes and penalties, an indirect (60-day) rollover from a qualified plan must be completed within:

  1. 60 days
  2. 30 days
  3. 90 days
  4. 1 year
Show answer
A. 60 days
A direct trustee-to-trustee transfer avoids the mandatory 20% withholding that applies to indirect rollovers from qualified plans.

18. In a split-dollar life insurance arrangement:

  1. The death benefit is divided among several beneficiaries
  2. An employer and employee share the premium payments and the policy benefits
  3. Premiums are split between two policies
  4. Two insurers split the risk
Show answer
B. An employer and employee share the premium payments and the policy benefits
Split-dollar plans are a way for employers to provide executives with life insurance.

19. Under a Section 162 executive bonus plan, the premium paid by the employer is:

  1. Not deductible and not taxable
  2. Taxable to the employer only
  3. Deductible to the employer and taxable income to the employee
  4. Deductible to the employee
Show answer
C. Deductible to the employer and taxable income to the employee
The employee owns the policy and names the beneficiary.

20. The human life value approach determines the amount of life insurance needed based on:

  1. The insured's net worth
  2. The family's specific expenses and goals
  3. A multiple of the insured's age
  4. The present value of the insured's future earnings lost at death
Show answer
D. The present value of the insured's future earnings lost at death
The needs approach looks at specific expenses such as debts, education, and income for survivors.

21. Life insurance proceeds are included in the insured's taxable estate if:

  1. The insured held any incidents of ownership in the policy at death
  2. The beneficiary is a child
  3. The policy is term insurance
  4. The proceeds are paid in a lump sum
Show answer
A. The insured held any incidents of ownership in the policy at death
Incidents of ownership include the right to change beneficiaries, borrow, or surrender the policy.

22. Premiums for a personally owned life insurance policy are:

  1. Deductible up to $5,000
  2. Deductible only for term policies
  3. Not tax deductible
  4. Fully tax deductible
Show answer
C. Not tax deductible
Personal life insurance premiums are a personal expense.

23. To be fully insured under Social Security, a worker generally needs:

  1. 10 quarters
  2. 20 quarters
  3. 6 quarters
  4. 40 quarters (credits) of coverage
Show answer
D. 40 quarters (credits) of coverage
Workers can earn up to four credits per year.

24. The Social Security blackout period is the time when a surviving spouse receives no benefits, which lasts from when the youngest child turns 16 until the spouse turns:

  1. 65
  2. 60
  3. 62
  4. 67
Show answer
B. 60
Life insurance is often used to fill the income gap during the blackout period.
Next topic: Insurance Basics Full life practice test