17 Free Washington Life & Health Practice Questions: Annuities and Federal Tax (2026)

Answer: B

B is correct because withdrawals from a life insurance policy's cash value are taxed under the FIFO (first-in, first-out) rule: amounts up to the basis (total premiums paid) are tax-free, and any amount exceeding the basis is taxed as ordinary income. A is incorrect because only the portion up to the basis is tax-free. C is incorrect because the 10% penalty applies only to Modified Endowment Contracts (MECs) or if the policyholder is under 59½ and takes a distribution from a qualified plan, not to standard life insurance policy withdrawals. D is incorrect because life insurance cash value withdrawals are not taxed as capital gains; they are taxed as ordinary income when exceeding basis.

Answer: A

A is correct because disability income benefits are tax-free if the premiums were paid with after-tax dollars, as the benefits are considered a return of after-tax premiums. B is incorrect because benefits are only taxable if premiums were paid with pre-tax dollars (e.g., through an employer plan). C is incorrect because there is no lost-wages threshold for taxation; the key factor is whether premiums were pre-tax or after-tax. D is incorrect because disability benefits are not subject to an excise tax; they are either taxable or tax-free based on premium funding.

Answer: D

D is correct because all earnings, including capital gains, dividends, and interest, within a variable annuity's sub-accounts grow tax-deferred. They are not distributed or taxed until withdrawal. A is incorrect because gains are not distributed annually; they remain invested and tax-deferred. B is incorrect because gains are not taxed as ordinary income during accumulation; they are tax-deferred. C is incorrect because while taxation is deferred, it is not exempt; earnings are taxed as ordinary income upon withdrawal.

Answer: D

For non-MEC annuities, withdrawals during the accumulation period follow the last-in, first-out (LIFO) rule: amounts are considered to come from earnings first and are taxed as ordinary income until the earnings are exhausted; only then is the basis returned tax-free. Thus, the portion exceeding the basis is taxed as ordinary income. Option A is incorrect because the basis portion is not taxed. Option B describes annuitization, not withdrawal. Option C is incorrect because earnings are taxed as ordinary income, not capital gains.

Answer: A

Under IRC § 7702A, a life insurance policy that fails the 7-pay test is classified as a Modified Endowment Contract (MEC). For MECs, cash value withdrawals and loans are taxed using the last-in, first-out (LIFO) rule, meaning earnings are withdrawn and taxed as ordinary income before the basis is accessed. Option B is incorrect because death benefits from a MEC remain income-tax-free. Option C is incorrect because the exclusion ratio applies to annuitization of non-MEC annuities, not MEC withdrawals. Option D is false; MECs remain subject to state insurance regulation.

Answer: D

Under the Health Insurance Portability and Accountability Act (HIPAA), benefits received from a qualified long-term care insurance contract are generally excluded from the insured's gross income, provided they do not exceed certain statutory daily or periodic limits (e.g., the IRS per-diem limit for the year, adjusted annually). Option A is incorrect because benefits are not automatically taxable. Option B is incorrect because there is no such 'actual cost' threshold for taxation. Option C is incorrect because tax-free treatment depends on the qualification of the contract and the limits, not permanent disability status.

Answer: D

A life income with 10-year period certain guarantees payments for the longer of the annuitant's life or 10 years. If the annuitant dies 15 years after the start date, they have lived beyond the 10-year guarantee period, so the life contingency has paid for 15 years and the period certain expired 5 years prior. At death, neither the life contingency (since the annuitant is deceased) nor the period certain (since it expired earlier) obligates further payments. Thus, payments stop immediately. Options A and B are incorrect because they misapply the guarantees. Option C is incorrect because period certain options do not typically commute to a lump sum upon death after the guarantee period.

Answer: D

The owner holds all contractual rights in an annuity, including the right to surrender, change beneficiaries, and select payout options. Upon the owner's death, these rights do not automatically transfer to the annuitant or beneficiary. If a successor owner was named in the contract, that person assumes the owner's rights. If not, the contract's terms and the insurance company's rules determine how the contract is handled, which may involve the estate or a designated successor. The annuitant's life only determines the payout amount; the beneficiary only receives proceeds upon the annuitant's death.

Answer: C

A key distinguishing feature of an HSA is that it is owned by the individual, not the employer. This makes it portable—it stays with the employee if they change jobs or leave the workforce. Additionally, unlike an FSA (which generally has a 'use-it-or-lose-it' provision), HSA funds roll over from year to year indefinitely if not used. While HSAs can be used to pay for certain health insurance premiums (like long-term care insurance, COBRA, or unemployment compensation premiums, and Medicare premiums after age 65), they cannot be used to pay for typical individual market health insurance premiums without tax consequences. HRAs are employer-owned and funded, and FSAs are employer-established but funded by employee salary reduction (with possible employer contributions).

Answer: C

Benefits received from a qualified long-term care insurance contract are generally excludable from income for federal income tax purposes, but only up to certain limits set by the IRS. For per-diem or periodic payment benefits (as opposed to reimbursement for actual expenses incurred), there is a maximum daily amount that can be excluded. For 2026, this limit is the IRS per-diem limit for the year. Since the benefit of $250 per day is below this limit, the entire amount would be excludable. However, if the benefit exceeded the daily limit, the excess would be taxable as ordinary income. The key point is that exclusion is not automatic; it is subject to these statutory limits. The recipient must also be chronically ill as defined by the Internal Revenue Code for the benefits to qualify for this favorable tax treatment.

Answer: D

Flexible Spending Accounts (FSAs) operate under a 'use-it-or-lose-it' principle, meaning that employees must incur and submit claims for reimbursement up to the amount they elected to contribute during the plan year, or they forfeit any unused funds. In this case, the employee contributed $2,800 via salary reduction, so the maximum amount available for reimbursement is $2,800. Even though they incurred $3,200 in qualified expenses, they can only be reimbursed up to their election amount of $2,800. Any unused portion of the $2,800 is forfeited at the end of the plan year (or grace period, if offered by the employer) and does not roll over. The salary reduction contributions are made on a pre-tax basis, so they are excluded from the employee's gross income and are not subject to federal income tax, Social Security, or Medicare taxes. Employer contributions are not required for employee contributions to be tax-free.

Answer: C

Premiums paid for individual accident and health insurance policies covering medical expenses are deductible as an itemized medical expense on Schedule A, subject to the 7.5% of adjusted gross income (AGI) floor. They are not deductible as a business expense unless the taxpayer is self-employed and meets specific criteria (which is not stated in the question). Premiums are not deductible if paid with pre-tax dollars through a cafeteria plan, but the question does not specify this scenario. The general rule for individually purchased policies is the itemized deduction subject to the AGI floor.

Answer: B

Under IRC Section 1035, exchanging a life insurance policy for an annuity contract is tax-free when done directly between insurers, provided no cash is received. The annuity contract assumes the basis (adjusted cost basis) of the life insurance policy for determining future taxable gains upon withdrawal or annuitization. Option A is incorrect because no gain is recognized in the exchange. Option C is incorrect as gains are not taxed at the time of exchange. Option D is incorrect because the type of annuity (immediate/deferred) or life insurance (term/permanent) does not affect the tax-free status of the exchange under Section 1035.

Answer: B

Under IRC Section 106, employer-paid premiums for accident and health insurance covering medical expenses are excludable from the employee's gross income. Additionally, if the employer offers a Section 125 cafeteria plan, employees can pay their share of premiums on a pre-tax basis through salary reduction, which also excludes those amounts from gross income and payroll taxes. Option A is incorrect because employer-paid premiums are not deductible by the employee; they are excluded from income. Option C is incorrect as the premiums are not taxable to the employee when paid by the employer or via pre-tax payroll deduction. Option D is incorrect because employer deductions are not contingent on employee reimbursement.

Answer: B

During the accumulation period, the death of the annuitant (if not the owner) does not terminate the annuity or trigger a death benefit. The annuity contract remains in force, and the owner retains all rights, including the ability to name a new annuitant, surrender, or annuitize later. The death benefit is only payable upon the death of the annuitant during the annuity (payout) period if a period certain or refund feature applies. Options A, C, and D incorrectly describe consequences that only apply during the payout period or misstate contract rights.

Answer: B

A variable annuity's defining feature during the accumulation period is that the cash value is not fixed but varies based on the investment performance of the sub-accounts chosen by the owner (e.g., equity, bond, or money market funds). There is no guarantee of principal or minimum return unless a separate rider is purchased. Options A and C describe features of fixed or indexed annuities, and Option D incorrectly limits investment choices.

Answer: C

For a non-MEC annuity, withdrawals during the accumulation period are taxed on a 'gain-first' basis (LIFO). The annuity has $15,000 of earnings ($90,000 cash value - $75,000 basis). The $10,000 withdrawal comes entirely from earnings, so the full amount is taxable as ordinary income. Option A is incorrect because basis is not withdrawn first. Option B incorrectly applies a pro-rata exclusion. Option D is incorrect because the withdrawal exceeds basis and is not tax-free.