Federal Tax Considerations — Life & Annuities: TX-LH practice questions

Federal Tax Considerations — Life & Annuities TX-LH-05-384

Logan, age 36, is the insured. He owns a non-MEC whole life policy with $35,000 basis and $50,000 cash value. He surrenders the policy entirely and receives $50,000 cash. How is the $50,000 taxed?

$50,000 tax-free under § 101(a). $15,000 ordinary income, plus the 10% penalty. $50,000 fully taxable as ordinary income. $15,000 ordinary income, with no 10% penalty.

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The answer is D: $15,000 ordinary income, with no 10% penalty.

Non-MEC life insurance surrenders use cost-recovery: basis comes out first, gain is ordinary income. The $15,000 gain ($50,000 − $35,000) is taxable as ordinary income. The 10% pre-59½ additional tax does NOT apply to surrenders of non-MEC life insurance policies — it applies to MEC distributions (IRC § 72(v)), non-qualified annuity distributions (§ 72(q)), and qualified plan distributions (§ 72(t)). § 101(a) applies only to death benefits.

Reviewed in our October 2026 Texas fact-check.

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Federal Tax Considerations — Life & Annuities TX-LH-05-385

A small business owns a $1,500,000 key-person life insurance policy on its CEO. The company paid $40,000 in premiums and the CEO dies. The company collects the $1,500,000. Assuming the company complied with the IRC § 101(j) employer-owned-life-insurance notice-and-consent requirements at issue, how is the death benefit taxed to the company?

$1,460,000 taxable; $40,000 basis recovery. $1,460,000 taxed at long-term capital gains rates. $0 — the full death benefit is income-tax-free. $1,500,000 fully taxable as ordinary corporate income.

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The answer is C: $0 — the full death benefit is income-tax-free.

Under IRC § 101(a), death benefits are generally income-tax-free even when received by a business. IRC § 101(j), enacted in 2006, limits the exclusion for employer-owned life insurance unless specific notice-and-consent requirements were met at issue and a statutory exception applies (employee, director, highly-compensated employee, etc.). When those requirements are met, the full death benefit retains its income-tax-free character.

Reviewed in our October 2026 Texas fact-check.

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Federal Tax Considerations — Life & Annuities TX-LH-05-388

Dr. Stevens has a SEP IRA worth $400,000 and wants to take a distribution at age 56 to start a new clinic. There is no qualifying exception. How is the distribution treated?

Tax-free because SEPs allow business reinvestment. Taxed at capital gains rates plus 10% penalty. Only the earnings are taxable; basis is tax-free. Ordinary income, plus the 10% additional tax.

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The answer is D: Ordinary income, plus the 10% additional tax.

SEP IRA contributions are entirely employer-funded pre-tax dollars, so there is no after-tax basis. Distributions are fully taxable as ordinary income. Because Dr. Stevens is under 59½ and no exception applies (starting a new business is not an exception), the 10% additional tax also applies.

Reviewed in our October 2026 Texas fact-check.

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Federal Tax Considerations — Life & Annuities TX-LH-05-389

Margaret has held her Roth IRA for 7 years. She is 58 and not disabled. She withdraws $20,000, all of which represents earnings (she has previously taken out her contributions). How is the $20,000 taxed?

Ordinary income plus 10% penalty; she is under 59½. Capital gains tax, with no penalty after 5 years. Ordinary income, but no penalty after 5 years. Tax-free, because the 5-year rule is satisfied.

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The answer is A: Ordinary income plus 10% penalty; she is under 59½.

A qualified (tax-free) Roth distribution requires BOTH the 5-year holding period AND age 59½ (or disability, death, or first-time homebuyer). Margaret meets the 5-year rule but not the 59½ test, so the earnings portion is non-qualified — taxable as ordinary income — and because she is under 59½ with no exception, the 10% penalty applies as well.

Reviewed in our October 2026 Texas fact-check.

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