Investment grade life insuranceArticle added by Lew Nason RFC, LUTCF on October 27, 2011
Lew Nason

Lew Nason RFC, LUTCF

Dallas, GA

Joined: October 13, 2006

My Company

This system has produced a remarkable overall record of solvency and safety. Only life insurance and annuities guarantee your investment principle and offer you minimum growth guarantees for the life of the contract.

We’ve talked a little about investment grade life insurance in previous articles. At this point, you may be asking what exactly is investment grade life insurance?

The simple explanation

Basically, investment grade life insurance is a permanent, cash value life insurance policy where you put significant additional cash into the policy over and above what is needed to support the policy’s death benefits.

In simple terms, you are purchasing the least amount of life insurance death benefit for the money you are investing. This allows your cash value to grow much faster because of the minimal internal expenses.

The technical explanation

In reality, the federal government has rules defining how much money can be deposited into a life insurance policy and still have it retain the unique income tax advantages of life insurance. These are the Tax Equity and Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984 and the Technical and Miscellaneous Revenue Act of 1988 guidelines.

What is generally considered to be an investment grade life insurance policy is a life insurance policy that has been funded up to the modified endowment contract rules. The policy is then able to accumulate significant amounts of cash value, while still retaining all the unique income tax advantages of a life insurance policy.

A permanent cash value life insurance policy offers several unique benefits that most other investment vehicles don’t offer:
  • Unlike qualified plans, there are no caps (limits) on how much money you can save each year. (You are only limited by the size of the policy.)

  • All of the money you put into a cash value life insurance policy builds tax deferred. You avoid paying income taxes every year, so your money builds faster.

  • You have a liquid emergency fund for life’s unexpected events.

  • The cash values can be accessed income tax-free, without contractual withdrawal penalties. And, there are no early withdrawal penalties from the federal government for withdrawals prior to age 59 ½. (Not so with qualified plans or annuities.)

  • Cash value life insurance is generally not attachable by creditors.

  • Cash value life insurance doesn’t count as an asset when you apply for college financial aid.
  • By over-funding a cash value life insurance policy up to the MEC guidelines, it can become investment grade life insurance.

  • The cash accumulated in your policy can provide you with a tax-free income in retirement (taking withdrawals up to the cost basis and then borrowing the remainder) as long as you keep the policy in-force.

  • You’ll have the protection of life insurance in your retirement years to replace lost pension and Social Security income at your death (“pension max” concept).

  • Unlike qualified plans and annuities, the death benefits and cash values are transferred income tax free to your beneficiaries.

  • Cash value life insurance generally bypasses probate (and it is private with no public records).

  • Cash value life insurance can be used to pay income taxes on qualified plans and your estate taxes at your death.

  • You have a disability waiver of premium rider that will put the money in for you. This makes the plan self-completing, if you ever become disabled. (Only life insurance offers this unique benefit.)

  • Life insurance provides a death benefit that gives your family the money you intended to save in the event you can’t be there.

  • Safety: All 50 states have something similar to FDIC for life insurance policies and annuities. Plus, insurance companies must, by law, cover at least 100 percent of their liabilities with reserves, hence the term “100 percent legal reserve life insurance company.” There are also regulations as to the percentage that can be held in certain forms of assets. This system has produced a remarkable overall record of solvency and safety.

  • Guarantees: Only life insurance and annuities guarantee your investment principle and offer you minimum growth guarantees for the life of the contract.
Tax treatment of life insurance

Life insurance policies receive very favorable tax treatment under the income tax laws. Section 101 of the Internal Revenue Code provides that the death benefit proceeds of a life insurance policy, subject to the exceptions stated in the law, are not subject to income tax when paid.

It also states that the cash value accumulation in a life insurance policy grows tax deferred and can be borrowed out tax free as long as the policy remains in force. These income tax benefits are just a few of many reasons for the exceptional growth of the life insurance industry.
Tax law changes

In the early 1980s, the introduction of universal life caused some confusion in and out of the insurance industry. Prior to TEFRA and DEFRA, there were not any specific federal laws defining life insurance. If a life insurance policy met the applicable state's requirements to be considered a life insurance policy, then the policy would be treated as life insurance for federal income tax purposes.

Universal life was the first policy to actively focus on the life insurance policy's cash value build-up as a supplemental income for a client's retirement years. Thus, the cash accumulation in the policy was a major focus for universal life sales.

Life insurance has since become one of the most attractive financial products someone can consider. What has been presented here is only a simplistic overview. As with any discussion of products and income taxes, there are always exceptions to the general rules.

Technical tax legislation review

With the passage of the TEFRA, Congress provided a mechanism to allow universal life-type policies to be treated as life insurance for tax purposes, thus providing the UL policies the tax benefits of IRS Section 101 treatment. TEFRA addressed only the flexible premium life insurance (universal life) and left open the need for a statutory definition of all life insurance.

Subsequent to TEFRA, DEFRA was passed. DEFRA took the TEFRA rules and modified them, providing a general set of qualifications for any contract to qualify as a life insurance policy for income tax purposes. Included were tests that effectively limited the amount of premium and required at least a minimum amount of pure risk coverage (death benefit) in order to qualify.

Thereafter, compliance to these laws has become a matter of mathematical calculation and ongoing testing to assure policies meet the statutory definition both at issue and while they remain in force.

By providing a consistent definition of life insurance, DEFRA effectively made it clear that all qualifying life insurance policies will be taxed under the favorable rules provided by the Internal Revenue Code. Basically, that means that the death benefits of a life insurance policy are generally received income tax free by the beneficiary.

This applies to the full death benefit, including the cash value component. This means that any interest portion included in the policy cash value and death benefit is free from federal income tax when paid as a death benefit.

TAMRA created a new category of life insurance policy called a modified endowment contract. TAMRA defines such a contract as one which fails to meet certain premium limitation tests, first on an annual and then on a cumulative basis. The TAMRA test period runs for seven years from the time it starts, hence its common name, seven-pay test.

As with TEFRA and DEFRA, compliance with TAMRA involves fairly straightforward mathematical computations performed by life insurance companies. It should be noted that death benefits of both types of policies (non-MECs and MECs) are generally paid free from income tax, including any cash value component. Policy distributions, however, are taxed differently depending on whether or not the life insurance policy is classified as a MEC.

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