Free CLU Practice Questions with Answers

Correct answer: D. Because a timely deferral election avoids constructive receipt, and her right to payment remains an unfunded, unsecured promise subject to a substantial risk of forfeiture from the company's general creditors

NQDC plans avoid current taxation through the combination of a timely deferral election (made before the compensation is earned, avoiding the constructive receipt doctrine) and the requirement that the promise to pay remain unfunded and unsecured — subject to the risk that the company's general creditors could reach it in insolvency. This is fundamentally different from qualified plans, which are funded, protected from employer creditors, and governed by ERISA's participation, vesting, and funding rules that NQDC 'top-hat' plans are largely exempt from.

• A. NQDC plans are intentionally unfunded arrangements; assets aren't held in a qualified trust exempt from the employer's creditors, since that kind of funding or security would itself trigger current taxation.
• B. She remains an employee for these purposes, and the deferred bonus is still compensation; being treated as a shareholder or receiving a return of capital isn't why it avoids current taxation.
• C. NQDC plans aren't automatically tax-exempt entities under ERISA, and they are unfunded arrangements whose assets remain subject to the employer's general creditors.
• D. A timely deferral election (made before the compensation is earned) avoids constructive receipt, and because her right to future payment is an unfunded, unsecured promise subject to the employer's general creditors, she isn't currently taxed on the deferred amount.

• Source: IRC section 409A (nonqualified deferred compensation)

Correct answer: A. A transfer to the insured, personally

The transfer-for-value rule (IRC Section 101(a)(2)) generally causes death proceeds to be taxed as ordinary income to the extent they exceed the transferee's basis, unless the transfer falls within a specific list of exceptions: transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, or transfers where the transferee's basis is determined by reference to the transferor's basis. A transfer to the insured personally is squarely on that exception list. The other choices — a friend, an unrelated investor, or a charity via annuity — do not fall within any statutory exception.

• A. Correct. A transfer to the insured personally is one of the statutory exceptions to the transfer-for-value rule, so the death proceeds retain their income-tax-free status.
• B. A friend with no insurable interest and no relationship falling within an enumerated exception (e.g., partner, corporate officer/shareholder of the insured) does not escape the rule; the proceeds beyond basis become taxable.
• C. A sale to an unrelated party purely for investment purposes is a textbook transfer-for-value trigger, not an exception, so the death benefit loses its full tax-free treatment.
• D. Transferring a policy to a charity in exchange for a private annuity involves valuable consideration (the annuity), which falls outside the narrow exceptions and can trigger transfer-for-value treatment.

Correct answer: C. $2,400

Substandard risk classes are commonly expressed as table ratings, where each table typically represents a 25% increment of extra mortality above standard. Table 4 corresponds to 100% extra mortality (4 x 25%). Applying that as a full loading to the $1,200 standard premium yields $1,200 + (100% x $1,200) = $2,400.

• A. $1,200 ignores the Table 4 rating entirely, applying only the standard premium.
• B. $1,800 reflects only a 50% extra-mortality loading, not the 100% loading that a Table 4 rating represents.
• C. Table 4 means 100% extra mortality, so the premium is loaded by an additional 100% of standard ($1,200), doubling it to $2,400.
• D. $3,600 reflects a 200% loading (more consistent with a Table 8 rating), overstating the actual Table 4 loading.

Correct answer: D. $15,000 is taxable ordinary income, and may also be subject to the 10% premature distribution penalty

Pre-annuitization withdrawals from a nonqualified annuity are taxed LIFO: gain comes out first. Since the $15,000 withdrawal is less than the $20,000 of accumulated earnings, the entire amount is taxable ordinary income. Because the owner is under 59½ and no exception applies, the 10% additional tax under Section 72(q) also applies.

• A. Incorrect — nonqualified annuities use LIFO (gain-first) taxation, not FIFO return-of-basis treatment.
• B. Incorrect — annuity earnings are taxed as ordinary income, not capital gains.
• C. Incorrect — this reverses the ordering rule; earnings are withdrawn first, not last, so the full $15,000 (not just $5,000) is taxable since it's less than the total gain.
• D. Correct. Under LIFO ordering, the $15,000 withdrawal comes entirely out of the $20,000 of earnings first, making it fully taxable ordinary income, and since she's under 59½ with no exception, the 10% penalty also applies.

Correct answer: D. Give an adverse action notice naming the consumer reporting agency and describing the applicant's rights to a free copy of the report and to dispute errors

When an adverse decision is based in whole or in part on a consumer report, the FCRA requires notice identifying the reporting agency and informing the applicant of the right to a free copy within 60 days and to dispute inaccurate information. The agency itself did not make the decision.

• A. The FCRA overrides general confidentiality by requiring a notice of adverse action.
• B. The FCRA requires the notice to name the consumer reporting agency so the applicant can get the report and dispute errors with that agency, not just question the insurer.
• C. No signed authorization is needed to send an adverse action notice.
• D. Correct. These are the required elements of an FCRA adverse action notice.

Correct answer: C. Aleatory

Aleatory means the dollar values exchanged by each party are inherently unequal and depend on a fortuitous, uncertain event (here, the timing of death) — a small premium can trigger a much larger payout, or the insurer could collect years of premiums and pay nothing if the policy lapses. Unilateral refers to only the insurer being bound to a promise after the premium is paid; adhesion refers to the take-it-or-leave-it drafting; conditional refers to the insured's duties as conditions precedent to payment.

• A. Unilateral describes how only the insurer makes an enforceable promise once premium is paid — it's about the structure of obligations, not the disparity in dollar value exchanged.
• B. Adhesion refers to the insurer drafting all contract terms on a take-it-or-leave-it basis — it addresses contract formation, not the mismatch between premiums paid and benefit paid.
• C. Correct. Aleatory describes an exchange of unequal values contingent on an uncertain event (death); a small premium outlay can trigger a much larger payout, exactly as shown here.
• D. Conditional refers to conditions that must be satisfied for coverage to apply — it doesn't describe the disproportionate value exchanged between the parties.

Correct answer: C. 5.0%, because the participated gain of 5.6% exceeds the cap and is limited to it

The stated order is participation first and cap second. 70% x 8% = 5.6%, which exceeds the 5% cap, so the credited rate is 5.0%; the 0% floor is not triggered.

• A. The policy does not credit the full index gain; participation and cap both limit it.
• B. The 5.6% participated gain exceeds the 5% cap, so the cap does bind and limits the credited rate.
• C. Correct. 5.6% is limited to the 5% cap.
• D. This multiplies the cap by the participation rate, which is not how the stated formula works.

Correct answer: A. The minimum coverage/nondiscrimination testing rules under IRC Section 410(b) and 401(a)(4)

Minimum coverage testing under Section 410(b), paired with the general nondiscrimination requirements of Section 401(a)(4), exists precisely to prevent qualified plans from disproportionately favoring highly compensated employees in coverage or benefits. RMDs, loan limits, and the incidental insurance rule address entirely different plan features.

• A. Correct. Disproportionate coverage favoring HCEs directly implicates the minimum coverage and nondiscrimination testing rules under IRC §410(b) and §401(a)(4).
• B. Incorrect — RMD rules under §401(a)(9) govern distribution timing, not coverage disparities between HCEs and NHCEs.
• C. Incorrect — plan loan limits are unrelated to which employees are covered by the plan.
• D. Incorrect — the incidental insurance benefit rule concerns how much life insurance a plan can hold, not coverage disparities among employee groups.

• Source: Treas. Reg. section 1.401(a)(4)-1 (nondiscrimination)

Correct answer: C. Disability buy-out (buy-sell) insurance, which pays a lump sum or installments toward the purchase price after a long elimination period (often a year or more), distinct from DI income-replacement policies with short elimination periods

Disability buy-out insurance is a distinct product designed specifically to fund a buy-sell agreement's disability trigger — it pays a lump sum or structured installments toward the purchase price of the disabled owner's interest, typically after a long elimination period (commonly 12-24 months) to confirm the disability is likely to be long-term/permanent, unlike ordinary DI income policies, which replace lost personal income with much shorter elimination periods (often 90 days) and pay monthly for as long as the disability continues. Key person disability and business overhead expense insurance serve entirely different purposes (protecting the business's cash flow or fixed costs, not funding an ownership buyout).

• A. Ordinary DI income insurance, built for short elimination periods and periodic income replacement, is not suited to fund a lump-sum ownership buyout; a distinct product exists for that purpose.
• B. Key person disability insurance protects the business against the loss of a key employee's contribution; it is not designed to fund the purchase of a disabled owner's equity interest.
• C. Disability buy-out insurance is specifically designed to fund an ownership buyout, typically paying a lump sum or installments after a long elimination period (often a year or more), unlike ordinary DI income policies with short elimination periods aimed at replacing periodic income.
• D. Business overhead expense insurance reimburses fixed operating costs during a disability and does not pay out a purchase price for an ownership interest.

Correct answer: C. The risk that estate taxes and settlement costs will force a distressed sale or liquidation of the family business to raise cash

Life insurance is a classic estate liquidity tool: it provides cash to pay estate taxes, debts, and administration expenses without forcing heirs to sell an illiquid asset like a family business under time pressure and at a discount. There is no legal requirement to sell a business at death, and this planning does not replace a buy-sell agreement or affect ongoing income tax on operations.

• A. Life insurance liquidity planning complements rather than eliminates the need for a buy-sell agreement, which separately governs the transfer of ownership interests.
• B. There's no legal requirement that closely held businesses be sold at an owner's death; the planning concern is the risk of a forced sale due to lack of liquidity, not a mandate to sell.
• C. Correct. The primary concern is that estate taxes and settlement costs could force a distressed sale of the illiquid family business; life insurance proceeds provide the cash to cover those costs instead.
• D. This addresses estate tax and settlement cost liquidity, not the business's ongoing income tax treatment of operating profits, which is an unrelated issue.

Correct answer: C. Spouse insuring spouse

The law presumes insurable interest automatically in immediate family relationships such as spouses (and close blood relatives), based on natural love and affection, without requiring proof of financial interest. In contrast, creditor-debtor, business partner, and employer-key employee relationships require the applicant to demonstrate an actual pecuniary interest in the insured's continued life to support the amount of coverage.

• A. A business partner generally must demonstrate an actual financial interest in the other partner; it isn't presumed automatically the way close family relationships are.
• B. A creditor's insurable interest in a debtor is generally limited to, and must be shown to relate to, the amount of the debt; it isn't presumed without proof.
• C. Spouses are presumed to have insurable interest in each other based on the marital relationship itself, without needing to separately prove a pecuniary interest.
• D. An employer insuring a key employee must generally establish the employee's financial value to the business; this interest is not presumed automatically.

Correct answer: A. Taxable in full as ordinary income, because the employee paid no premiums with after-tax dollars

Disability benefits are excluded under IRC 104(a)(3) only to the extent the employee paid the premiums with after-tax dollars. When the employer pays and the cost is not taxed to the employee, benefits are fully taxable under IRC 105(a).

• A. Correct. Employer-paid, nontaxed premiums make the benefits fully taxable.
• B. The exclusion depends on who paid the premium and how it was taxed, so it does not cover employer-paid, untaxed premiums.
• C. A recovery-of-premium approach applies to employee-paid, after-tax contributions, not to employer-paid premiums.
• D. A 50% inclusion rule is a feature of certain Social Security benefit taxation, not of employer-paid disability plans.

• Source: IRC section 104 (compensation for injuries or sickness)
• Source: IRC section 105 (amounts received under health plans)

Correct answer: C. $5,700

Flat extra premiums are charged per $1,000 of face amount, so $5 × 500 (thousands of face amount) = $2,500, added to the standard premium of $3,200, for a first-year total of $5,700.

• A. $3,200 omits the flat extra charge entirely, which must be added on top of the standard premium.
• B. $3,700 doesn't match the flat extra calculation of $5 per $1,000 on a $500,000 face amount.
• C. The flat extra is $5 x 500 (in thousands of face amount) = $2,500, added to the standard $3,200 premium, for a total of $5,700 in the first policy year.
• D. $8,200 overstates the flat extra, as if the rate were roughly $10 per $1,000 rather than the stated $5 per $1,000.

Correct answer: C. As though the insured survived the beneficiary, so the proceeds pass to the contingent beneficiary, or the insured's estate if none is named

Under the Uniform Simultaneous Death Act (absent policy language to the contrary), when it cannot be established who died first, each person's property is distributed as though they survived the other — meaning the insured is treated as having outlived the beneficiary. Proceeds therefore pass to a named contingent beneficiary, or to the insured's estate if no contingent beneficiary was named, rather than to the primary beneficiary's estate.

• A. There's no legal presumption that spouses died simultaneously for beneficiary-designation purposes, and the beneficiary's estate does not take ahead of the insured's side; the USDA instead presumes the insured survived the beneficiary.
• B. The USDA does not split proceeds evenly between the estates; it applies the presumption that the insured survived the beneficiary.
• C. Under the USDA, when the order of death can't be established, the insured is treated as having survived the beneficiary, so proceeds pass to the contingent beneficiary, or the insured's estate if none is named.
• D. The policy is not voided under the USDA; proceeds are still paid, under the presumption that the insured survived the beneficiary.

Correct answer: B. Both a state life insurance producer license and an appropriate securities registration (such as an applicable FINRA registration)

Because VUL cash value performance is tied to investment subaccounts rather than the insurer's general account, VUL (and variable life generally) is regulated as a security under federal securities law, requiring SEC/FINRA-related registration in addition to the usual state life insurance license — dual licensing is a defining compliance feature of variable products.

• A. Incorrect — a life license alone is insufficient for a security-classified product, regardless of the fact that a licensed insurer issues the policy.
• B. Correct — variable products require both an insurance license and securities registration.
• C. Incorrect — VUL's investment component makes it a regulated security, so selling it requires licensure and registration.
• D. Incorrect — a CPA license has no bearing on the ability to sell a security or insurance product, and it cannot replace the insurance license.

Correct answer: A. Unfunded and maintained primarily for a select group of management or highly compensated employees

ERISA's stringent participation, vesting, and funding rules apply to plans covering rank-and-file employees generally. Top-hat plans are exempt from most of these requirements precisely because they are unfunded (a mere promise to pay, with assets remaining subject to the employer's general creditors) and limited to a select group of management or highly compensated employees, who are presumed to have the bargaining power to negotiate their own protections.

• A. Correct. A top-hat plan is exempt from ERISA's participation, vesting, and funding rules because it is unfunded and limited to a select group of management or highly compensated employees.
• B. Fabricated — the ERISA exemption isn't tied to funding with employer stock; a plan funded through a trust set aside for executives would actually be funded, not exempt.
• C. Incorrect — this is the opposite condition; a top-hat plan must be limited to a select group, not open to employees at all pay levels, to retain its ERISA exemption.
• D. Incorrect — top-hat plans are unfunded and unsecured, and are not insured by the PBGC at any benefit level.

Correct answer: B. It may be disregarded for estate tax valuation, because the agreement fails the bona fide business arrangement, device, and arm's-length comparability tests

IRC 2703 disregards a buy-sell price for transfer-tax valuation unless the agreement is a bona fide business arrangement, is not a device to pass property to family for less than full value, and has terms comparable to arm's-length deals. A family agreement meant to shift value fails these tests.

• A. A contract price does not automatically fix estate tax value; IRC 2703 overrides prices that fail its tests.
• B. Correct. All three IRC 2703(b) tests must be met, and a value-shifting family agreement fails.
• C. IRC 2703 contains no midpoint or 25 percent compromise rule; a price that fails the statutory tests is simply disregarded.
• D. The three-year period belongs to IRC 2035 and does not validate a buy-sell price.

Correct answer: B. Included in the gross estate because the transfer of the policy occurred within three years of death

IRC Section 2035 pulls the value of life insurance proceeds back into the transferor's gross estate if the insured transferred an existing policy (or relinquished incidents of ownership) within three years of death. Twenty months is within that three-year window, so despite the completed and irrevocable nature of the transfer, the proceeds are includible.

• A. Incorrect. Completeness/irrevocability does not override the Section 2035 three-year inclusion rule for existing policies.
• B. Correct. Twenty months is within the three-year lookback, triggering inclusion in the gross estate.
• C. Incorrect. Section 2035 inclusion is at the transferor-decedent's estate level, not merely a trust-level tax issue.
• D. Incorrect. ILITs receive no blanket exemption from Section 2035; the timing of the transfer still matters.

• Source: IRC section 2035 (gifts within 3 years of death)

Correct answer: C. The tendency of individuals with higher-than-average risk to seek insurance in disproportionate numbers

Adverse selection describes the tendency of higher-risk individuals — who know their own risk better than the insurer does — to seek insurance in greater proportion than lower-risk individuals, potentially skewing the insured pool if not controlled by underwriting. It's a market/behavioral phenomenon, not an underwriting action itself.

• A. This describes underwriting selection by the insurer, the opposite of adverse selection, which describes applicant behavior.
• B. Rating an applicant as substandard is an underwriting response to identified risk, not the definition of adverse selection itself.
• C. Adverse selection is the tendency of higher-than-average risk individuals to seek insurance in disproportionate numbers relative to lower-risk individuals.
• D. Rescinding a policy for material misrepresentation is a separate legal remedy, unrelated to the concept of adverse selection.

Correct answer: B. The two contracts must be aggregated as one contract for tax purposes, so gain from Contract 1 determines the taxable portion of the withdrawal

Annuities issued by the same company to the same owner within the same calendar year are aggregated and treated as a single contract for taxation of distributions. Combined, the two contracts have $10,000 gain and $5,000 loss, netting to $5,000 of gain, so up to $5,000 of the $10,000 withdrawal from Contract 2 is taxable under LIFO ordering even though Contract 2 alone shows no gain.

• A. Incorrect — the aggregation rule prevents treating Contract 2 in isolation; because both were purchased from the same insurer in the same year, gain in either contract can be reached by a withdrawal from the other.
• B. Correct. Same-year, same-insurer nonqualified annuities are aggregated and treated as one contract for taxation, so the combined $10,000 gain (net of the $5,000 loss, i.e., $5,000 total gain) determines how much of any withdrawal is taxable, with the withdrawal taxed as gain first.
• C. Incorrect — aggregation of same-year, same-insurer contracts is mandatory, not elective, so no election is needed and Contract 2 can't be tested in isolation.
• D. Fabricated — taxation isn't determined by the order in which contract numbers were issued or listed.

Correct answer: C. Marital status of the applicant

Build, family medical history, and tobacco/nicotine use are all classic mortality risk factors used in underwriting classification. Marital status is not a traditional medical/mortality underwriting factor, though it can occasionally play into financial underwriting/insurable interest discussions in a very different context.

• A. Build (height/weight) is a standard traditional mortality risk factor underwriters routinely evaluate.
• B. Family history of hereditary conditions is a traditional factor used to assess future mortality/morbidity risk.
• C. Marital status is not a traditional medical/mortality risk factor in individual life underwriting, unlike build, family history, or tobacco use.
• D. Tobacco/nicotine use is one of the most significant traditional mortality risk factors underwriters assess.

Correct answer: C. The insurer must pay the full death benefit because the contestable period has already expired

The incontestability clause bars the insurer from contesting the policy — even for material misrepresentations discovered later — once the specified contestable period (here, 2 years) has elapsed and the insured is still living or has since died, absent fraud rising to the level most states still allow to be contested (which was not shown here). Materiality alone doesn't override an expired incontestability clause; that's precisely the protection the clause is designed to provide.

• A. The insurer cannot deny the claim on these facts because the 2-year contestable period expired before death, cutting off the ability to contest for non-fraudulent misrepresentation even if the insurer relied on them.
• B. There is no general proportional-reduction remedy for weight or health omissions after the contestable period has run (that concept applies specifically to age/sex misstatement clauses, not this scenario) — the incontestability clause bars adjustment here too.
• C. Correct. Since the policy has been in force for 3 years — beyond the 2-year contestable period — and there's no fraud, the incontestability clause bars the insurer from contesting the misstatements, so the full death benefit must be paid.
• D. Rescission requires the misstatements to be contestable; after the contestable period expires (absent fraud), the insurer loses the right to rescind, making this remedy unavailable.

Correct answer: C. $21,200

Simple interest accrues on the loan balance: $20,000 × 6% = $1,200 for the year, so $21,200 is owed and would be deducted from the cash surrender value at surrender.

• A. Incorrect — this ignores the year's accrued loan interest entirely.
• B. Incorrect — this understates the interest; 6% simple interest on $20,000 for one year is $1,200, not $600.
• C. Correct. $20,000 × 6% = $1,200 in interest, so $20,000 + $1,200 = $21,200 is deducted from the cash surrender value.
• D. Incorrect — this overstates the interest charge beyond the correct 6% simple interest calculation.

Correct answer: A. A defined benefit plan promises a specified retirement benefit determined by a formula (e.g., years of service and salary), with the employer bearing investment risk; a defined contribution plan allocates contributions to individual accounts, with the participant bearing investment risk

A defined benefit plan fixes the retirement benefit via a formula and shifts investment and longevity risk to the employer, who must fund whatever is needed to meet that promise. A defined contribution plan (e.g., 401(k), profit-sharing) fixes only the contribution; the eventual benefit depends on investment performance in the participant's individual account, so the participant bears that risk. The wrong choices reverse or misstate this fundamental distinction: one swaps the two plan types, one says both use individual accounts with participant risk, and one describes DB plans as funded by salary deferrals when they are typically employer-funded based on actuarial projections.

• A. Correct. A defined benefit plan promises a formula-based benefit (e.g., tied to service and salary) with the employer bearing investment risk, while a defined contribution plan allocates contributions to individual accounts, putting investment risk on the participant.
• B. This reverses the roles. It is the defined benefit plan, not the defined contribution plan, that promises a formula-based benefit with the employer bearing investment risk.
• C. Defined benefit plans do not use individual participant accounts or shift investment risk to the participant; the employer bears that risk, which is the fundamental distinction between the two plan types.
• D. Defined benefit plans are typically funded by the employer based on actuarial requirements, while salary deferrals into participant-directed accounts are characteristic of DC plans like 401(k)s; this choice reverses the roles, including the promised-benefit funding.

Correct answer: A. The policy proceeds and cash value are generally reachable by the corporation's creditors, since they are corporate assets

Because the corporation owns the policy, the cash value and death proceeds are corporate assets and remain subject to the claims of the corporation's general creditors until actually used to complete the redemption (cash value is also exposed during the corporation's lifetime). In a cross-purchase arrangement, individual shareholders own their respective policies, and those policies/proceeds are not corporate assets, insulating them from the business's creditors. B and D are factually incorrect, and C misstates the tax treatment (death proceeds are still generally received income tax-free under §101(a); creditor exposure is a business-risk issue, not a tax issue).

• A. Correct. Because the corporation owns the policy, both cash value and proceeds are corporate assets and are generally exposed to claims of the corporation's general creditors — a risk cross-purchase policies (owned personally by each shareholder) avoid.
• B. A corporation can be both owner and beneficiary of a policy on a shareholder's life; that is exactly how a stock redemption arrangement is structured, and no third-party trustee is required.
• C. Life insurance death proceeds received by a corporate beneficiary are generally income-tax-free under IRC §101(a), not taxed as ordinary income to the extent of gain, so this isn't the distinguishing risk.
• D. The shareholders' insurable interest in each other isn't affected by which entity owns the policies; insurable interest exists independently of the funding structure chosen.