18 Free Texas Life & Annuity Taxation Practice Questions (2026)

Question 1 (Chapter 5)

Sarah, a Texas resident, purchases a new whole life insurance policy to provide for her family. She diligently pays her monthly premiums. When preparing her federal income taxes for the year, she consults her tax advisor about deducting these premiums. What advice will her tax advisor most likely give her regarding the deductibility of her life insurance premiums?

• A) The premiums are fully deductible as a personal investment expense.
• B) The premiums are deductible only if the policy's cash value exceeds a certain threshold.
• C) The premiums are generally not tax-deductible for individuals.
• D) The premiums are deductible, but only up to a maximum of $5,000 per year.

Question 2 (Chapter 5)

Jennifer, a self-employed graphic designer in Austin, pays $4,200 annually in premiums on a personal whole life policy she owns on herself. Her CPA asks whether she can deduct these premiums as a business expense on her Schedule C since she runs her own LLC. What is the correct federal income tax treatment?

• A) She may deduct the full $4,200 because she is self-employed.
• B) She may deduct 50% of the premium as a partial business expense.
• C) The premiums are not deductible because they are paid on a personal life insurance policy.
• D) She may deduct the premiums only if her business carries a key-person policy on her.

Question 3 (Chapter 5)

Michael, 45, owns a universal life insurance policy that has accumulated significant cash value over the years. He has never taken a loan or withdrawal from the policy. He is considering using the accumulated cash value for a future goal but is concerned about immediate tax implications. How is the growth of the cash value in Michael's policy typically treated for federal income tax purposes?

• A) The annual growth in cash value is taxable as ordinary income each year it accumulates.
• B) The growth in cash value is tax-deferred, meaning taxes are only due upon withdrawal or surrender.
• C) The growth in cash value is entirely tax-exempt, similar to a Roth IRA.
• D) Only the portion of the growth that exceeds the total premiums paid is taxable annually.

Question 4 (Chapter 5)

Marcus, age 42, owns a universal life policy with $80,000 of cash value and a $48,000 cost basis. The policy is NOT a MEC. He borrows $30,000 against the cash value to remodel his kitchen and keeps the policy in force. How is the $30,000 loan treated for federal income tax purposes in the year he receives it?

• A) The entire $30,000 is taxable as ordinary income because it exceeds the basis.
• B) $30,000 is treated as a LIFO distribution; earnings are taxed first.
• C) The loan is not a taxable distribution because the policy is not a MEC and remains in force.
• D) The loan triggers a 10% penalty because Marcus is under 59½.

Question 5 (Chapter 5)

Bryce, age 40 and the insured, owns a non-MEC universal life policy. The policy has $20,000 basis and $35,000 cash value. He withdraws $18,000 (partial withdrawal, not a loan, policy stays in force). How is the withdrawal taxed under standard non-MEC cost recovery?

• A) $18,000 ordinary income (LIFO) — earnings first.
• B) Tax-free — $18,000 is less than the $20,000 basis, so it's a full return of basis under cost recovery (FIFO).
• C) $18,000 taxable plus 10% penalty.
• D) $10,286 tax-free; $7,714 taxable (pro-rata).

Question 6 (Chapter 5)

Marcus owns a $500,000 universal life policy on his own life. He needs cash and surrenders the policy for its full cash value of $80,000. His total premiums paid into the policy were $50,000, and the policy is not a MEC. How much, if any, is taxable as ordinary income?

• A) $0 — all life insurance distributions are tax-free.
• B) $30,000 — the gain above his basis.
• C) $80,000 — the full surrender amount.
• D) $50,000 — equal to his premiums paid.

Question 7 (Chapter 5)

Rachel purchased a whole life policy with a $250,000 face amount in 2023. The 7-pay net level premium for the policy is $4,800 per year. By the end of year 3, she has paid cumulative premiums of $18,000. Has the policy failed the 7-pay test?

• A) No, because cumulative premiums of $18,000 do not exceed 3 × $4,800 = $14,400.
• B) Yes, because cumulative premiums of $18,000 exceed the cumulative 7-pay limit of $14,400 for year 3.
• C) No, because the 7-pay test only applies after year 7.
• D) Yes, but only if the policy is surrendered before year 7.

Question 8 (Chapter 5)

After purchasing a whole life policy, David decided to pay a large lump sum premium in the third year, significantly exceeding the amount allowed by the 7-pay test. As a result, his policy was reclassified as a Modified Endowment Contract (MEC). Years later, at age 55, David needs funds and decides to take a cash withdrawal from his MEC. What are the likely tax consequences of this withdrawal?

• A) The withdrawal will be treated as 'first-in, first-out' (FIFO), with premiums returned first, then earnings, and no penalty.
• B) The withdrawal will be taxed on a 'last-in, first-out' (LIFO) basis, and a 10% penalty tax will apply to the taxable portion.
• C) The withdrawal is entirely tax-free, as it is from a life insurance policy.
• D) Only the portion of the withdrawal exceeding the total death benefit will be taxable.

Question 9 (Chapter 5)

Bianca, age 60, is the insured under a MEC. She withdraws $15,000 from the policy. The policy has $40,000 basis and $20,000 of gain. How is the withdrawal taxed?

• A) $15,000 ordinary income, plus 10% penalty.
• B) $15,000 ordinary income, NO 10% penalty (over 59½).
• C) $15,000 tax-free as return of basis.
• D) $5,000 taxable, $10,000 tax-free.

Question 10 (Chapter 5)

A client, Mr. Henderson, owns an existing whole life insurance policy that he purchased several years ago. He is now interested in exchanging it for a new, larger whole life policy with a different insurer, without incurring current taxation on the accumulated cash value. Which of the following exchanges would qualify as a tax-free §1035 exchange INTO a new whole life policy?

• A) Exchanging his whole life policy for a Roth IRA contribution.
• B) Exchanging his whole life policy for a new whole life policy.
• C) Exchanging his whole life policy for a long-term care insurance policy.
• D) Exchanging his whole life policy for a mutual fund investment.

Question 11 (Chapter 5)

Carlos owns a non-qualified deferred annuity with $90,000 of basis and $150,000 of accumulated value. He wants to exchange it tax-free for a new permanent life insurance policy with better death-benefit coverage. Is this a valid § 1035 exchange?

• A) Yes — any annuity-to-insurance exchange qualifies for tax-free treatment.
• B) Yes, but only if the new policy has a face amount of at least $250,000.
• C) No — an annuity contract cannot be exchanged tax-free for a life insurance policy under § 1035.
• D) Yes, but he must pay tax on the $60,000 gain first.

Question 12 (Chapter 5)

Mark exchanges his $300,000 variable annuity (basis $100,000) for a new fixed indexed annuity at a different carrier, using IRC § 1035. What is the basis in the new contract immediately after the exchange?

• A) $0 — basis is reset to zero on exchange.
• B) $300,000 — basis steps up to current value.
• C) $100,000 — basis carries over from the old contract.
• D) $200,000 — only the gain portion carries.

Question 13 (Chapter 5)

Vivian, age 70, is receiving payments from her non-qualified single-premium immediate annuity. She paid $200,000 in premium, and her expected return is $320,000 over 16 years ($20,000/year). Using the IRC § 72(b) exclusion ratio, how much of each $20,000 annual payment is taxable?

• A) $0 — non-qualified annuity payments are tax-free.
• B) $7,500 — the taxable (earnings) portion.
• C) $12,500 — the excluded (basis) portion.
• D) $20,000 — the entire payment is taxable.

Question 14 (Chapter 5)

Brett, age 54, owns a non-qualified deferred annuity with $70,000 basis and $110,000 accumulated value. He has not annuitized. He takes a $25,000 partial withdrawal. How is it taxed?

• A) Entirely tax-free as return of basis.
• B) $25,000 taxable as ordinary income (LIFO) plus a 10% penalty on the taxable portion.
• C) $25,000 taxed at long-term capital gains rates with no penalty.
• D) Pro-rata: $15,909 basis, $9,091 earnings; only earnings taxed, no penalty.

Question 15 (Chapter 5)

Ruby paid $200,000 over the years into her non-qualified annuity. She annuitized and was projected to receive $400,000 over 20 years ($20,000/year). After 22 years, she has fully recovered her $200,000 basis, but she's still alive and the contract pays for life. How is each subsequent annual payment taxed?

• A) Continue with the 50% exclusion ratio.
• B) 100% taxable as ordinary income — once basis is fully recovered, the exclusion ends.
• C) 100% tax-free — she has 'paid in full.'
• D) Capital gains tax applies to subsequent payments.

Question 16 (Chapter 5)

Anita died at age 71 owning a $750,000 term life policy. Her son Raj is the named beneficiary. Anita's basis (total premiums paid over the years) was $42,000. How much of the $750,000 death benefit is includible in Raj's gross income for federal income tax purposes?

• A) $750,000 — the entire amount.
• B) $708,000 — the amount exceeding premiums paid.
• C) $0 — under IRC § 101(a), death benefits paid by reason of the insured's death are excluded from gross income.
• D) $42,000 — only the basis is excluded; the rest is taxable.

Question 17 (Chapter 5)

Joseph dies owning a $400,000 life insurance policy with $90,000 in cash value. His named beneficiary is his daughter Eliza. Eliza elects to receive the proceeds as a 10-year installment payout rather than a lump sum. Each annual payment of approximately $44,000 includes some interest. How is Eliza taxed?

• A) All $440,000+ is income-tax-free under § 101(a).
• B) The $400,000 principal portion is income-tax-free; the interest earned on the deferred amounts is taxable as ordinary income.
• C) The entire installment payout is taxable.
• D) Only the original cash value of $90,000 is income-tax-free.

Question 18 (Chapter 5)

Sophia owned a $1,000,000 life insurance policy on her own life. To reduce her potential estate, she gifted the policy outright to her daughter Mia and retained no incidents of ownership. Sophia died 22 months after the transfer. What is the federal estate-tax consequence?

• A) Excluded from Sophia's gross estate — she no longer owned the policy.
• B) Included in Sophia's gross estate because of the 3-year rule under IRC § 2035.
• C) Included in Mia's gross estate as constructive ownership.
• D) Excluded from any estate because it was a gift.