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What Is The Definition of Life Insurance For Income Tax Purposes?

What the Tax Code Says

The tax code specifically defines life insurance for income tax purposes. If an insurance policy does not meet this definition, it may not be treated as life insurance by the IRS with respect to the policyholder. So long as the policy is life insurance under the applicable law, however, the beneficiary may exclude from income death benefits received under the contract.

To meet the definition(s), the policy must pass certain tests. It is important that your policy meet all the tests during its entire life. If not, you (the policyowner) and the beneficiaries may be subject to significant consequences, such as: (1) the income on the policy being subject to income tax in the year in which it is earned and (2) the death benefit being treated as taxable income to the beneficiary or beneficiaries at your death.

Determined By Type of Policy and Date Issued

The applicable definition(s) of life insurance depends on the type of policy and when it was issued:

  • Contracts issued after 1984 must pass either the cash value accumulation test or a guideline premium/cash value corridor test (Code Sec. 7702 (a))
  • Variable life insurance policies must also satisfy the diversification rules under Code Sec. 817(h)
  • Flexible premium policies issued before 1985 must satisfy Code Sec. 101(f)
  • Other policies issued before 1985 must satisfy requirements established by IRS rulings and case law

Plus What Local Law Says

A life insurance policy must also qualify as life insurance under applicable state or foreign law.

Caution: Certain life insurance policies that satisfy the tax code's definition of life insurance are considered modified endowment contracts if they fail to meet the so-called 7-pay test. The federal tax treatment of these contracts is different from the tax treatment of other life insurance contracts.

Why Does The Tax Code Specifically Define Life Insurance?

Definition According to Webster's

Webster's dictionary defines life insurance as "insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured."

Life Insurance Versus Investments

So, why isn't Webster's good enough for the Internal Revenue Code? Because this definition encompasses all types of life insurance policies, including those that have large investment components. Life insurance has many income tax advantages. However, pure investments are not given the same advantageous tax treatment. The tax code's definition is meant to properly classify policies as life insurance or investment vehicles so that appropriate tax treatment can be applied.

Do You Really Want to Know What The Definition Is?

Be forewarned. The discussion that follows is necessarily complex and not easily understood. You may want a tax specialist to assist you. In addition, your life insurance agent should be aware of all that follows, and he or she should be able to help you find a policy that meets all the technical requirements.

Tip: It's not unreasonable to request a written guarantee from your insurance company that your policy falls within all applicable definitions.

What Is The Cash Value Accumulation Test?

This test is generally used for whole life policies. A contract meets the cash value accumulation test if, by its terms, the cash surrender value may not at any time exceed the net single premium that would have to be paid out at such time to fund future benefits.

What does this mean? Well, some definitions might help:

  • The cash surrender value is its full redeemable value determined without regard to surrender charges, policy loan, or reasonable termination dividends (as opposed to the net surrender value of a contract, which is determined with regard to surrender charges but without regard to any policy loans).
  • The net single premium does not refer to amounts you pay to the insurance company (generally called premiums). It refers to the total amount needed by the insurance company to fund future benefits.
  • Future benefits means death benefits or the amount payable because the insured has died, determined without regard to any qualified additional benefits

Still confused? Here is the Senate Finance Committee's statement regarding the test: "This test is intended to allow traditional whole life policies, with cash values that accumulate based on reasonable interest rates, to continue to qualify as life insurance contracts." In other words, the cash value is allowed to accumulate, but only to a certain extent. After that, the contract becomes an investment, at least for purposes of the Tax Code.

The Rules That Apply

To calculate the net single premium for this test, some rules apply. The net single premium determination is made:

  • On the basis of interest at the greater of an annual effective rate of 4 percent (or 3 percent in the case of a qualified 20-pay contract) or the rate or rates guaranteed on issuance

Technical Note: A qualified 20-pay contract is any contract that requires at least 20 non-decreasing annual premium payments and is issued under a plan of insurance in existence before September 28, 1983.

  • On the basis of reasonable mortality charges that meet the requirements prescribed in the IRS regulations (currently proposed) as of the time the policy is issued
  • By taking into account only current and future death benefits and qualified additional benefits

Also, in the case of qualified additional benefits:

  • On the basis of reasonable charges (other than mortality charges) specified in the contract that are reasonably expected to actually be paid to the policyholder (on the basis of the insurance company's relevant past experience or, if none, on the basis of the industry's past experience)

Technical Note: Qualified additional benefits include guaranteed insurability, an accidental death or disability benefit, family term coverage, a disability waiver of premium, or other benefits prescribed under regulations. They are not treated as future benefits.

What Is The Guideline Premium/Cash Value Corridor Test?

An Alternative to the Cash Value Accumulation Test

Your policy need only pass either the cash value accumulation test or the guideline premium/cash value corridor test, but not both. The guideline premium/cash value corridor test is generally applied to universal life and adjustable life policies.

Two Tests in One

The guideline premium/cash value corridor test is really two tests in one: the guideline premium test and the cash value corridor test. Both halves of the test must be passed.

What Is The Guideline Premium Test?

Contract Must Meet the Guideline Premium Requirements

A contract meets the guideline premium requirements if the sum of all the premiums paid under the contract does not at any time exceed the guideline premium limitation.

Guideline Premium Limitation

The guideline premium limitation means, as of any date, the greater of:

  • The guideline single premium
  • The sum of the guideline level premiums

Tip: The guideline premium limitation is increased if the contract provides long-term care insurance coverage.

Tip: The payment of a premium that would result in the sum of the premiums paid exceeding the guideline premium limitation is disregarded if (1) the amount of the premium does not exceed the amount necessary to prevent termination of the contract on or before the end of the contract year, and (2) the contract will have no cash surrender value at the end of the extension period.

Guideline Single Premium

The guideline single premium means the premium necessary to fund future benefits under the contract (or, in other words, the total benefit).

The basis for determining the guideline single premium includes the following:

  • An assumed rate of interest at the greater of an annual effective rate of 6 percent or the rate or rates guaranteed on issuance
  • Reasonable mortality charges that meet the requirements prescribed in the regulations, if any, and that do not exceed the mortality charges specified in the prevailing commissioner's standard tables (under Code Sec. 807(d)(5)) as of the time the policy is issued
  • Reasonable charges (other than mortality charges) specified in the contract that are reasonably expected to actually be paid to the policyholder (on the basis of the insurance company's relevant past experience or, if none, on the basis of the industry's past experience)

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Guideline Level Premiums

The guideline level premium means the level annual amount (payable over a period not ending before the insured attains age 95) computed on the same basis as the guideline single premium, except that the assumed rate of interest is at the greater of an annual effective rate of four percent or the rate or rates guaranteed on issuance.

What "Premium Paid" Means for Purposes of the Guideline Premium Test

Premium paid means the payments made under the contract less (1) amounts not received as an annuity (e.g., withdrawals and dividends) and not included in the policyholder's gross income; (2) certain premiums paid in excess of the limitations and returned to the policyholder; and (3) any other amounts received with respect to the contract that are specified in the regulations.

Caution: Remember that this is only one-half of the test. The cash value corridor test must also be passed.

What Is The Cash Value Corridor Test?

A contract passes the cash value corridor test if the death benefit under the contract at any time is not less than the applicable percentage of the cash surrender value. The cash surrender value is determined without regard to any surrender charge, policy loan, or reasonable termination dividends. The applicable percentage is determined by using a table included in the Internal Revenue Code. When using the table, the insured's age is as of the beginning of the contract year, not as of his or her birthday.

Caution: Remember that this is only one-half of the test. The guideline premium test must also be passed.

What Are The Rules For The Cash Value Accumulation And Guideline Premium Tests?

Assumptions

In implementing the preceding tests, the following assumptions are made:

  • The death benefit and any qualified additional benefit do not increase
  • The maturity date is no earlier than the day on which the insured attains age 95 and no later than the day on which the insured attains age 100
  • The death benefits are provided until the maturity date
  • The amount of any endowment benefit does not exceed the least amount payable as a death benefit at any time under the contract

Exceptions to the Assumptions

Of course, for every rule, there are one or more exceptions:

  • For the purposes of computing the guideline level premium, an increase in the death benefit that is provided in the contract may be taken into account but only to the extent necessary to prevent a decrease in the excess of the death benefit over the cash surrender value of the contract.
  • For the purposes of the cash value accumulation test, the increase described above may be taken into account if the contract will meet such a test at all times, assuming that the net level reserve is substituted for the net single premium.
  • For purposes of the cash value accumulation test, the death benefit increases may be taken into account if the contract (1) has an initial benefit of $5,000 or less and a maximum death benefit of $25,000 or less, (2) provides for a fixed predetermined annual increase not to exceed 10 percent of the initial death benefit or 8 percent of the death benefit at the end of the preceding year, and (3) was purchased to cover payment of burial expenses or in connection with prearranged funeral expenses.

Tip: These rules do not apply to the cash value corridor test.

What If You Make a Change In the Contract?

You Must Keep the Policy In Compliance At All Times

Remember that all the tests need to be passed during the entire life of the policy. But changes are made to policies all the time (e.g., you may add more money or reduce your coverage). So, if you make a material change to your policy, you should be aware that you may need to act to keep the policy in compliance.

Changes During First 15 Years of The Contract

If there is a reduction in benefits during the first 15 years (beginning on the date the policy is issued), a recalculation is necessary. If the tests are no longer met, cash must be distributed from the contract until it is again in compliance. Generally, this distribution is treated as taxable ordinary income (instead of tax-free return of basis) to the extent it exceeds the recapture ceiling.

Recapture Ceiling in First Five Years

  • Cash value accumulation test--In the case of changes to a contract that has passed the cash value accumulation test, the recapture ceiling is the amount by which the cash surrender value (immediately before the reduction in benefits) exceeds the net single premium (immediately after the reduction in benefits).
  • Guideline premium/cash value corridor test--Where changes to policies pass the guideline premium/cash value corridor test, the recapture ceiling is the greater of (1) the amount by which the aggregate premiums paid (immediately before the reduction in benefits) exceeds the guideline premium limitation (immediately after the reduction in benefits) or (2) the amount by which the cash surrender value (immediately before the reduction in benefits) exceeds the cash value corridor (immediately after the reduction in benefits).

Recapture Ceiling in Years 6-15

The recapture ceiling for changes that occur between years 6 and 15 of any contract (regardless of which test was passed) is the excess of the cash surrender value (immediately before the reduction in benefits) over the cash value corridor (immediately after the reduction in benefits).

Technical Note: A material change does not include when riders treated as qualified long-term care insurance are issued or when any provision required to conform to any other long-term care rider is added.

What If The Policy Fails By Mistake?

If you can show that your policy failed at some point because of a reasonable error and that you took reasonable steps to correct the failure, the failure may be waived.

Are There Special Rules for Churches?

Yes. Certain self-funded church death benefit plans need not fulfill the requirement that the policy must also qualify as life insurance under applicable state or foreign law. These policies must provide for the payment of benefits by reason of the death of the covered individual and be provided by a church (es) for the benefit of its employees or their beneficiaries.

What If The Policy Is A Variable Life Policy?

Test More Often

If you have a variable life policy, you must determine whether the tests have been met each time the death benefit changes, or at least once a year.

Caution: Variable life insurance and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.

Plus, Requirements Under Code Sec. 817(H)

In addition, the policy must satisfy the diversification requirements imposed by Code Sec. 817(h) and the underlying regulations.

This section requires that the assets held in your account (which must be kept separate if it is a variable policy) be adequately diversified. Adequate diversification generally means any of the following:

  • No more than 55 percent of the value of the total assets in the account represents any one investment alone
  • No more than 70 percent of the value of the total assets in the account represents any two investments alone
  • No more than 80 percent of the value of the total assets in the account represents any three investments alone
  • No more than 90 percent of the value of the total assets in the account represents any four investments alone

The Safe Harbor Requirement

Assets held in a separate account are adequately diversified if:

  • The separate account is a regulated investment company (as defined in Code Sec. 851(b)(3), and
  • No more than 55 percent of the value of the total assets in the account is attributable to cash, cash equivalents (e.g., accounts receivable), government securities, and securities of other regulated investment companies

What Rules Apply If You Have A Pre-1985 Flexible Premium Policy?

Pre-1985 flexible premium policies must conform to Code Sec.101 (f) in order for the full death benefits to be excluded from the income of the beneficiary. Failure to satisfy Code Sec.101 (f) causes the policy to be treated as a combination term policy and investment (e.g., an annuity). Only death benefits attributed to the part treated as a term policy are excluded from income for income tax purposes.

Technical Note: A flexible premium contract is one that provides for the payment of one or more premiums that are not fixed as to both timing and amount.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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