Small Tax Change May Have Big Impact on Life Insurance

A narrow but sweeping change to federal tax law embedded in the year-end omnibus spending and coronavirus relief bill applies new math to the interest rates used to set some life insurance policies . The updates, adopted as part of the Consolidated Appropriations Act, 2021 (HR 133) – could usher in a healthier selling environment for life insurers and a greater savings opportunity for consumers, experts say.

Key points to remember

  • A provision of the federal spending bill signed into law at the end of the year changes a tax code rule that applies to certain life insurance policies.
  • Under IRC Section 7702, the law adjusts key interest rates that were set over 35 years ago and are used to set tax-advantaged permanent life insurance policies .
  • The change is remarkable because more and more people today rely on life insurance for more than just the death benefit.

What changed?

The law changes the Section 7702 of the tax code, which defines how the policies qualify as life insurance contracts under the tax code. It also specifies how much money can accumulate in a life insurance policy without being currently taxed.

To qualify as life insurance for federal tax purposes, these policies must meet one of two criteria: cash value capitalization test or the guideline premium test. They are designed to cap the proportion of cash value to the total face amount of a policy and the amount of premiums that can be paid.

Previously, code limits required life insurers to credit interest rates of 4% on the cash surrender value of permanent life insurance and other long-term life insurance policies so policies maintain coverage until death. The problem? Section 7702 was written in 1984, when interest rates were much higher than today’s historic lows.

Without adjusting outdated rates to better match current pandemic-influenced economic conditions, insurer groups feared the issuance of new permanent life insurance policies would be at risk, as would the rates of return companies generate. on the investments that support the payments of their life insurance contracts.

These concerns were significant, given that permanent life insurance policies currently make up 59% of the individual life insurance market, according to data from the American Council of Life Insurers (ACLI).

“The impact of COVID on already historically low interest rates has pushed the design and funding of permanent life insurance policies to a breaking point,” says Paul Graham, ACLI’s senior vice president for policy development. “With these changes, the significantly reduced interest income can now be offset by the premium dollars the policyholder will pay, so policies can achieve their expected death benefit over the life of the policy.”

The new law lowers the key interest rate used to create life insurance policies to 2% for 2021 and then ties future rates to periodically updated benchmarks. The discount comes into effect on January 1, 2021 for new policies. If market interest rates normalize in the future, Section 7702 would revert to prior rates.

What is the impact ?


Section 7702 was created to distinguish between real life insurance policies and investment vehicles impersonating them, to ensure that only real policies receive favorable tax treatment.

The new provision should help permanent life insurance policies continue to be characterized as tax-advantaged life insurance contracts and avoid being classified as other investments whose benefits would be taxed as ordinary income. .

Additionally, the revision makes it easier for insurers to offer and sell permanent life insurance policies, notes Michel Leonard, CBE, vice president and senior economist at the Insurance Information Institute. And for consumers and policyholders, the change can create the possibility of greater financial security, typically increasing the amounts policyholders can contribute to cash value life insurance accounts. (Permanent life insurance policies have a savings component, creating cash value that policyholders can tap into.)

What Does Driving Life Insurance Need?

The law change is also noteworthy in light of the fact that consumers’ goals for purchasing life insurance are changing, with more relying on these policies for financial security and retirement.

More than half of American adults (54%) own some type of life insurance, according to LIMRA consumer research. But the reasons for owning it have changed over the past couple of years. Covering final expenses has declined as a motivation in 2020, LIMRA found, while saving for retirement has increased.

And while the COVID-19 pandemic contributed to a decline in life insurance sales in the first half of 2020, LIMRA expects most whole and term life insurance products to return to pre-COVID-19 sales growth. pandemic in 2021 and 2022.

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