CLU Income Taxation Practice Questions

Correct answer: B. The dividend is generally treated as a nontaxable return of premium (not taxable, up to basis), while interest credited on dividends left on deposit is taxable annually as it's earned

Policy dividends from a participating policy are generally treated as a return of a portion of the premium the policyholder already paid (not taxable income), since the policyholder is essentially getting back an overcharge, up to the amount of basis. However, if the dividend is left on deposit with the insurer and earns interest, that interest is taxable annually as ordinary income in the year credited, just like interest on any other deposit. A reverses the treatment; C and D both mischaracterize one piece of the arrangement.

• AA. Incorrect. The dividend itself is not taxable when received (it's treated as a return of premium up to basis), and the interest on dividends left on deposit is taxed currently rather than deferred until withdrawal.
• BB. Correct. Dividends are generally a nontaxable return of premium up to basis, while any interest credited on dividends left on deposit is taxable annually as earned.
• CC. Incorrect. The interest earned on dividends left on deposit is taxable annually; it's not tax-free just because the dividend itself is a return of premium.
• DD. Incorrect. The dividend itself is not taxed as ordinary income when credited; only the interest it earns is taxed currently.

• Source: 26 U.S.C. § 72, accessed October 2026

Correct answer: B. Not currently taxable; growth accumulates on a tax-deferred basis inside the policy

As long as a contract qualifies as life insurance under IRC §7702, the 'inside buildup' of cash value is not currently taxed to the policyholder. It grows tax-deferred, similar to a retirement account, and is only potentially taxed upon a taxable distribution event (withdrawal above basis, a lapse/surrender with an outstanding loan exceeding basis, or full surrender for a gain). A and C incorrectly assume annual current taxation like a typical brokerage account; D incorrectly assumes permanent tax exemption regardless of how funds are eventually accessed.

• AA. Incorrect. Inside cash value growth in a life policy is not currently taxed as ordinary income while it stays inside the contract.
• BB. Correct. As long as the contract qualifies as life insurance under §7702, annual cash value growth accumulates tax-deferred and isn't currently taxed absent a withdrawal, loan default, or surrender.
• CC. Incorrect. The growth is not taxed annually as capital gain either; it is tax-deferred, not currently recognized at all.
• DD. Incorrect. Growth is only tax-deferred, not permanently tax-exempt; amounts withdrawn or received in excess of basis can become taxable.

• Source: 26 U.S.C. § 7702, accessed October 2026
• Source: 26 U.S.C. § 72, accessed October 2026

Correct answer: B. The proceeds are taxable to Wendy above her basis (amount paid plus subsequent premiums), because the sale to an unrelated party triggered the transfer-for-value rule and none of the exceptions (e.g., transfer to the insured, a partner of the insured, or a partnership in which the insured is a partner) apply

The transfer-for-value rule (§101(a)(2)) taxes death proceeds above the transferee's basis when a policy is transferred for valuable consideration, unless the transfer falls within an exception. Notably, transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer/shareholder. Wendy is an unrelated third party who doesn't fit any exception, so she must include the proceeds in income to the extent they exceed her basis. A ignores the transfer-for-value rule entirely; C mistakes 'adequate consideration' for a shield against ordinary income exposure; D mischaracterizes the character of the income (it's ordinary income under the transfer-for-value rule, not capital gain).

• AA. Incorrect. The transfer-for-value rule strips away the usual §101(a) full exclusion when a policy is sold to an unrelated party for valuable consideration, so a sale for full value does change the result.
• BB. Correct. Selling to an unrelated third party for valuable consideration triggers the transfer-for-value rule, and since none of the exceptions (transfer to the insured, a partner of the insured, or a partnership in which the insured is a partner) apply here, Wendy is taxed on proceeds exceeding her basis (price paid plus subsequent premiums).
• CC. Incorrect. Paying adequate consideration doesn't cure a transfer-for-value violation; the rule is triggered by a transfer for value, and only the specific statutory exceptions avoid it, none of which fit this sale.
• DD. Incorrect. The taxable portion under the transfer-for-value rule is ordinary income, not long-term capital gain, and the holding period does not change that.

• Source: IRC section 101 (death benefits), accessed October 2026

Correct answer: B. The $30,000 withdrawal is taxed as ordinary income to the extent of gain (LIFO, gain-first) and is also subject to a 10% penalty tax since the policyowner is under 59½ with no exception; however, the death benefit at death is still fully excludible from income under §101(a), since MEC status affects only lifetime distributions, not the death benefit

MEC distributions (withdrawals, loans) are taxed on a LIFO (gain-first) basis rather than the FIFO (basis-first) treatment of non-MEC policies. With a $90,000 CSV and $50,000 basis (i.e., $40,000 of gain), the $30,000 withdrawal is taxed first out of gain. Fully taxable ordinary income here, since it doesn't exceed the $40,000 of gain. Because the policyowner is under 59½ with no applicable exception (disability, death, substantially equal periodic payments, etc.), IRC §72(v) imposes an additional 10% penalty tax on the taxable portion. Critically, MEC status changes only the taxation of lifetime distributions. The death benefit itself remains fully excludible under §101(a) when ultimately paid by reason of death. A and C incorrectly extend MEC's harsher treatment to the death benefit; D misstates both the amount subject to tax and to penalty.

• AA. Incorrect. MEC withdrawals are not a tax-free return of basis; they're taxed gain-first. This option also wrongly makes the death benefit taxable, which MEC status doesn't affect.
• BB. Correct. The withdrawal is taxed LIFO (gain-first) as ordinary income up to the $30,000 of gain, plus a 10% penalty since she's under 59½ with no exception, but the death benefit remains fully excludible under §101(a) because MEC status only affects lifetime distributions.
• CC. Incorrect. MEC status doesn't make the death benefit taxable; the §101(a) exclusion still applies to death proceeds, and the withdrawal is taxed only to the extent of gain.
• DD. Incorrect. The withdrawal isn't tax-free because MEC distributions come out gain-first, and the 10% penalty applies only to the taxable portion, not the entire cash surrender value.

• Source: IRC section 101 (death benefits), accessed October 2026

Correct answer: C. $25,000 of ordinary income, the excess of the amount deemed distributed (the forgiven loan/cash value) over her basis

When a policy lapses with an outstanding loan, the cash value used to satisfy (forgive) that loan is treated as an amount distributed to the owner. Gain equals that deemed distribution ($65,000) minus basis ($40,000) = $25,000, taxed as ordinary income. Even though Priya walks away with no cash. This is the classic 'phantom income' trap of lapsed policy loans.

• AA. A lapse with an outstanding loan can still trigger taxable income even without net cash to the policyowner, because the forgiven loan is treated as a distribution to the extent it exceeds basis.
• BB. The entire loan balance is not taxed as "boot"; only the amount by which the deemed distribution exceeds Priya's basis is taxable.
• CC. Correct. The $65,000 forgiven loan is treated as a distribution; since her basis is $40,000, the excess of $25,000 is taxable as ordinary income in the year of lapse.
• DD. Life insurance policies do not generate a deductible capital loss on lapse; the tax result here is ordinary income on the gain, not a loss.

• Source: 26 U.S.C. § 72, accessed October 2026

Correct answer: B. Excludible from her gross income under IRC §101(a)

Under IRC §101(a)(1), life insurance death benefits paid by reason of the insured's death are generally excluded from the beneficiary's gross income in full, regardless of the relationship between premiums paid and death benefit amount, unless an exception applies (e.g., transfer-for-value). A, C, and D describe treatment that does not apply to a straightforward death benefit payout.

• AA. Life insurance death benefits are generally excluded from gross income, not fully includible, under the governing Internal Revenue Code section.
• BB. Correct. Under IRC §101(a), death benefits paid by reason of the insured's death are generally excludible from the beneficiary's gross income, assuming no transfer-for-value issue and no accrued interest.
• CC. This basis-limited taxation describes a different product (like an annuity's exclusion ratio), not a life insurance death benefit, which is excludible in full under §101(a).
• DD. Life insurance death proceeds aren't taxed as capital gain; they are simply excluded from income under §101(a).

• Source: IRC section 101 (death benefits), accessed October 2026
• Source: Treas. Reg. section 1.101-1 (death proceeds exclusion), accessed October 2026

Correct answer: A. Cash surrender value received, minus the policyowner's cost basis (generally cumulative premiums paid, minus any prior nontaxable withdrawals)

On a full surrender of a non-MEC policy, taxable gain equals the cash surrender value received in excess of the policyowner's investment in the contract (cost basis). Generally cumulative premiums paid, reduced by any previously received nontaxable amounts such as prior withdrawals of basis or dividends taken in cash. Only the excess over basis is taxed as ordinary income; return of basis is not taxable.

• AA. Correct. Gain on surrender equals proceeds minus basis (cumulative premiums, adjusted).
• BB. Incorrect. Face amount is the death benefit, irrelevant to a lifetime surrender gain calculation.
• CC. Incorrect. Basis recovery is not taxable; only the excess over basis is taxed.
• DD. Incorrect. This formula is both inverted and mischaracterizes any shortfall as a deductible ordinary loss, which is not how life insurance surrenders are treated.

• Source: 26 U.S.C. § 72, accessed October 2026