17 Free California Life & Health Practice Questions: Federal Tax Considerations for Life & Annuities (2026)
How to Use This Set
Taxation is a small block on the California Life objectives, 3 of 75 questions, but it is a block with clear rules and few surprises, which makes it some of the most reliable marks on the exam. Tax ideas also appear inside annuity and policy questions.
The rules are federal, so they do not change with where you work. The skill is knowing which of a handful of outcomes applies: income-tax-free death benefits, gain taxed first on MEC distributions, an exclusion ratio on annuity payments, and the permitted tax-free exchanges under IRC Section 1035.
Work through the questions, open each answer only after you have committed to one, and read the explanation even when you were right. Part of the learning is seeing why the wrong options are wrong.
Practice Questions 1-6: Premiums, Death Benefits, Loans and Annuity Payments
Who gets a deduction, what a beneficiary receives tax-free, and how annuity payouts split between basis and gain.
Question 1 (Chapter 5)
A small business owner in San Jose, California, is considering offering a group term life insurance policy to his 15 employees. He asks his insurance agent about the tax implications for the business regarding the premiums paid. Which of the following statements is most accurate regarding the employer's tax treatment of these premiums?
- A) The employer-paid premiums are considered taxable income to the employees.
- B) The employer-paid premiums are never deductible, regardless of the type of group policy.
- C) Only premiums for key employees are deductible for the employer.
- D) The employer-paid premiums are generally a deductible business expense for the employer.
Show answer & explanation
Answer: D
Employer-paid premiums for group life insurance are generally considered a deductible business expense for the employer. This encourages employers to provide benefits to their workforce. Option A describes the employee's tax situation for coverage above the IRC threshold, not the employer's deductibility. Options B and C are incorrect.
Question 2 (Chapter 5)
Upon the death of her husband, Mrs. Rodriguez, a beneficiary in California, receives a lump-sum death benefit of $500,000 from his life insurance policy. She asks her financial advisor about the tax implications of this payment. What is the typical federal income tax treatment of this lump-sum death benefit?
- A) The entire $500,000 is taxable as ordinary income to Mrs. Rodriguez.
- B) Only the portion exceeding the premiums paid by her husband is taxable.
- C) The death benefit is subject to a 10% federal penalty tax if received before age 59½.
- D) The death benefit proceeds are generally income-tax-free to the beneficiary.
Show answer & explanation
Answer: D
One of the most significant tax advantages of life insurance is that the death benefit proceeds paid in a lump sum to a named beneficiary are generally income-tax-free. Options A and B are incorrect. Option C applies to certain distributions from Modified Endowment Contracts or qualified plans, not typically to life insurance death benefits.
Question 3 (Chapter 5)
Ms. Garcia has a non-MEC (Modified Endowment Contract) whole life insurance policy. She needs funds for a home renovation and decides to take a policy loan. She asks her agent about the tax implications of taking this loan. What should the agent advise her?
- A) Policy loans from a non-MEC are generally taxable as ordinary income immediately upon receipt.
- B) Policy loans are tax-free only if repaid within one year.
- C) Policy loans are subject to a 10% penalty if taken before age 59½.
- D) Policy loans from a non-MEC are not taxable as long as the policy remains in force.
Show answer & explanation
Answer: D
Policy loans from a non-MEC life insurance policy are generally not considered taxable income as long as the policy remains in force. They are treated as a loan against the policy's cash value, not a distribution. If the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis could become taxable. Options A, B, and C are incorrect; C applies to MECs or qualified plans.
Question 4 (Chapter 5)
Mrs. Davis begins receiving income payments from her nonqualified deferred annuity. She contributed $100,000 in premiums, and the annuity has grown to $150,000. She will receive $1,000 per month. How will each payment be treated for federal income tax purposes?
- A) Each payment will be partially taxable and partially a tax-free return of principal, determined by the exclusion ratio.
- B) Each payment will be fully taxable as ordinary income.
- C) Each payment will be fully tax-free, as it includes a return of her original principal.
- D) Only payments received after her original $100,000 contribution has been returned are taxable.
Show answer & explanation
Answer: A
Payments from a nonqualified annuity are taxed using an exclusion ratio. This ratio determines the portion of each payment that is considered a tax-free return of the annuitant's cost basis (premiums paid) and the portion that is taxable gain. Options B, C, and D are incorrect because they do not reflect the exclusion ratio method for nonqualified annuities.
Question 5 (Chapter 5)
Which of the following exchanges is NOT permitted as a tax-free exchange under IRC Section 1035?
- A) A life insurance policy for another life insurance policy.
- B) A life insurance policy for an annuity.
- C) An annuity for another annuity.
- D) An annuity for a life insurance policy.
Show answer & explanation
Answer: D
IRC Section 1035 permits tax-free exchanges of life insurance policies for other life insurance policies, life insurance policies for annuities, and annuities for other annuities. However, an exchange of an annuity for a life insurance policy is NOT permitted as a tax-free exchange because it would allow for tax-deferred growth in the annuity to then become part of a tax-free death benefit, which is not allowed under the current tax code.
Question 6 (Chapter 5)
Ms. Chen has a participating whole life insurance policy that has paid her annual dividends for several years. She has always received them as a return of premium, which has been tax-free. This year, due to significant policy growth and a long policy duration, the dividend she received actually exceeded her total cost basis in the policy. How will the portion of the dividend that exceeds her cost basis be treated for federal income tax purposes?
- A) It will be treated as a capital gain and taxed at a lower rate.
- B) It will remain entirely tax-free, regardless of the amount.
- C) It will be added to her policy's cash value and taxed only upon surrender.
- D) It will be treated as ordinary income and subject to taxation.
Show answer & explanation
Answer: D
Policy dividends are generally considered a return of premium and are not taxable until they exceed the policyholder's cost basis (total premiums paid minus previous non-taxable dividends). Once the cumulative dividends received exceed the cost basis, any additional dividend amounts are considered taxable income, treated as ordinary income. Option A is incorrect as it's not a capital gain. Option B is incorrect because the tax-free treatment only applies up to the cost basis. Option C is incorrect; while dividends can be used to purchase paid-up additions, the portion exceeding basis is taxable upon receipt, not deferred until surrender.
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Practice Questions 7-12: Loan Interest, Group Term, 1035 Exchanges and MECs
The tax treatment of loans and group coverage, which exchanges are tax-free, and why overfunding is a problem.
Question 7 (Chapter 5)
Ms. Rodriguez has a non-MEC whole life insurance policy and took a policy loan two years ago. She is now diligently repaying the loan, including interest. For federal income tax purposes, how are the interest payments Ms. Rodriguez makes on her policy loan typically treated?
- A) The interest payments are tax-deductible for the policyholder.
- B) The interest payments are considered taxable income to the insurer.
- C) The interest payments reduce the policy's cost basis.
- D) The interest payments are generally not tax-deductible for the policyholder.
Show answer & explanation
Answer: D
Interest paid on a policy loan is generally not tax-deductible for the policyholder. Policy loans are not considered true debt for tax purposes in the same way a bank loan is, as the collateral is the policy's own cash value. Option A is incorrect. Option B is true that the insurer receives the interest, but the question is about the policyholder's tax treatment. Option C is incorrect; interest payments do not reduce the cost basis; they are simply part of repaying the loan.
Question 8 (Chapter 5)
An employer in Los Angeles provides group term life insurance coverage to all employees. For an employee, what is the federal income tax treatment of the cost of the first $50,000 of employer-provided group term life insurance coverage?
- A) The cost of the first $50,000 is fully taxable to the employee as imputed income.
- B) The cost of the first $50,000 is tax-deductible for the employee.
- C) The cost of the first $50,000 is generally tax-free to the employee.
- D) The cost of the first $50,000 is only taxable if the employee is a highly compensated individual.
Show answer & explanation
Answer: C
Under federal tax law, the cost of the first $50,000 of employer-provided group term life insurance coverage is generally tax-free to the employee. Only the cost of coverage exceeding $50,000 is considered imputed income to the employee and is taxable. Option A is incorrect. Option B is incorrect as it's not deductible by the employee. Option D is incorrect; the $50,000 exclusion applies to all employees, though specific rules apply to highly compensated employees regarding non-discrimination.
Question 9 (Chapter 5)
Arthur, age 45, owns a nonqualified deferred annuity. He decides to exchange his current annuity for a new annuity contract with a different insurer to take advantage of better interest rates. Which of the following best describes the tax consequence of this transaction under IRC Section 1035?
- A) The exchange is a taxable event, and Arthur must pay taxes on the entire accumulated gain.
- B) The exchange is tax-free, but Arthur must reset his cost basis to zero.
- C) The exchange is only tax-free if the new annuity is with the same insurance company.
- D) The exchange is tax-free, and Arthur's cost basis in the old annuity carries over to the new annuity.
Show answer & explanation
Answer: D
IRC Section 1035 allows for tax-free exchanges of annuity-for-annuity, life-for-life, or life-for-annuity. The cost basis transfers to the new contract, deferring tax until a later distribution.
Question 10 (Chapter 5)
A client asks if they can perform a 1035 exchange to move their current annuity into a new life insurance policy. What should the agent advise?
- A) Yes, this is permitted under IRC Section 1035.
- B) Yes, but only if the annuity is currently in the accumulation phase.
- C) No, an annuity cannot be exchanged for a life insurance policy under Section 1035.
- D) Yes, but it will be treated as a taxable surrender first.
Show answer & explanation
Answer: C
IRC Section 1035 allows life-to-life, life-to-annuity, and annuity-to-annuity, but specifically prohibits annuity-to-life exchanges because it would allow tax-deferred annuity gains to move into a vehicle (life insurance) that provides a tax-free death benefit.
Question 11 (Chapter 5)
A client asks why they should avoid overfunding their life insurance policy. How should the agent explain the risk of a MEC classification?
- A) The death benefit will become taxable.
- B) The cash value will no longer grow tax-deferred.
- C) The premiums will no longer be deductible.
- D) Future access to cash value via loans or withdrawals will be subject to less favorable tax treatment (LIFO).
Show answer & explanation
Answer: D
The primary disadvantage of a MEC is the loss of tax-advantaged access to cash value. Distributions and loans are taxed as gains first (LIFO) and may incur a 10% penalty.
Question 12 (Chapter 5)
Which of the following is true regarding the taxation of interest earned on dividends left to accumulate with the insurer?
- A) It is tax-free until the policy is surrendered.
- B) It is taxable in the year it is credited to the policyholder's account.
- C) It is only taxable if the policyholder is over 59½.
- D) It is treated as a return of premium.
Show answer & explanation
Answer: B
While the dividend itself is a return of premium, the interest earned on that dividend is considered taxable income in the year it is earned.
Practice Questions 13-17: MEC Status, Annuity Exchanges, Maturity and the 7-Pay Test
Permanent MEC status, the exchange that is not allowed, and the test that decides when a policy is a MEC.
Question 13 (Chapter 5)
If a life insurance policy is classified as a MEC, can it ever lose that status?
- A) Yes, if the policyholder stops paying premiums for 7 years.
- B) Yes, if the policy is exchanged for a new policy.
- C) No, once a MEC, always a MEC.
- D) Yes, if the cash value drops below the cost basis.
Show answer & explanation
Answer: C
Under the IRC, the MEC status is permanent. Once a policy is classified as a MEC, it remains a MEC for the life of the contract.
Question 14 (Chapter 5)
A client is considering a 1035 exchange to move funds from an old annuity into a new life insurance policy. What must the agent advise regarding the tax-free status of this specific exchange?
- A) The exchange is tax-free because all 1035 exchanges are permitted.
- B) The exchange is tax-free only if the insurer is the same.
- C) The exchange is not permitted as a tax-free 1035 exchange.
- D) The exchange is tax-free but subject to a 10% surrender penalty.
Show answer & explanation
Answer: C
IRC Section 1035 allows for tax-free exchanges of life-to-life, life-to-annuity, and annuity-to-annuity. However, an annuity-to-life exchange is not permitted under Section 1035 because it would allow tax-deferred annuity gains to be moved into a life policy, which has more favorable tax treatment for death benefits.
Question 15 (Chapter 5)
A life insurance policy matures at age 121. The cash value equals the face amount of $100,000. If the policyholder's total premiums paid (cost basis) were $70,000, how much of the $100,000 payout is taxable?
- A) $0
- B) $30,000
- C) $70,000
- D) $100,000
Show answer & explanation
Answer: B
When a policy matures, the amount received in excess of the cost basis is taxable as ordinary income. $100,000 - $70,000 = $30,000 taxable gain.
Question 16 (Chapter 5)
What is the primary purpose of the 7-pay test in relation to life insurance policies?
- A) To determine the maximum death benefit allowed.
- B) To determine if a policy is a MEC.
- C) To calculate the annual dividend payout.
- D) To set the minimum premium for a universal life policy.
Show answer & explanation
Answer: B
The 7-pay test is the mechanism used to determine if a policy is overfunded. If the premiums paid during the first seven years exceed the net level premiums that would have been paid to provide paid-up future benefits, the policy is classified as a MEC.
Question 17 (Chapter 5)
If a beneficiary receives the death benefit of a life insurance policy, what is the federal income tax impact?
- A) The proceeds are fully taxable as ordinary income.
- B) The proceeds are generally income-tax-free.
- C) The proceeds are taxable only if they exceed $1 million.
- D) The proceeds are taxable as a capital gain.
Show answer & explanation
Answer: B
Life insurance death benefits paid in a lump sum are generally income-tax-free to the beneficiary under federal tax law.
The Mistakes That Cost Marks
Thinking a 1035 exchange works in every direction. Life to life, life to annuity and annuity to annuity are tax-free. Annuity to life is not.
Treating MEC loans like ordinary policy loans. On a MEC, distributions and loans are taxed gain first (LIFO) and may carry a 10% penalty. On a non-MEC, loans are generally not taxable income while the policy stays in force.
Believing MEC status can be undone. Once a policy fails the 7-pay test and becomes a MEC, it stays a MEC.
Deducting policy loan interest. Interest paid on a policy loan is generally not tax-deductible.
Taxing the whole annuity payment. Payments from a nonqualified annuity use an exclusion ratio: part is a tax-free return of basis, part is taxable gain.
Forgetting the $50,000 group term threshold. The cost of the first $50,000 of employer-provided group term coverage is tax-free to the employee. Only the cost of coverage above it is imputed income.
Your Next Step
Score yourself honestly: how many of the 17 did you get right before opening the answer? Re-do any you missed tomorrow, not today. A question you can answer cold after a day is one you can answer in the exam.
For the other topic sets, see the California Life & Health practice question hub. To hear this material as audio and keep going with the rest of the course, start the free preview.
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