Since January, the life insurance industry has been abuzz about the changes to IRC Section 7702, the section of the tax code which defines what constitutes life insurance. The changes were a part of the Consolidated Appropriations Act 2021 (the “Act”), a law to continue funding the federal government, and the inclusion of changes to §7702 was both expected and unexpected.
Expected, in that the industry had been working for a number of years to get the attention of legislators in order to address life insurance policy funding challenges which were becoming more serious as interest rates dropped. Unexpected, because little movement toward enactment had been witnessed until, suddenly, it was a done deal.
Inside baseball
Many credit Massachusetts U.S. Representative Richard Neal, the Chairman of the powerful House Ways & Means Committee, and the MassMutual Life Insurance Company for working together to push the changes over the finish line. “Richie” Neal was once a MassMutual agent and his district includes the home office of the carrier in Springfield, MA so this partnership comes as no surprise.
What happened?
Specifically, the Act changed the minimum statutory interest rate assumptions used to calculate premium funding limits under IRC §§7702 and 7702(a) so that the rates for new policies are no longer fixed once a policy is in-force and are allowed to change as often as once a year. In addition, the starting fixed rates for new policies were increased.
Why is this a big deal? Under most circumstances, policyholders of whole life insurance policies will be able to place more premium into their policies, sometimes upward of three times as much or more.
In understanding the impact of the Act, it is important to recall the history of §7702 and its establishment of the definition of life insurance. Section 7702 was put into effect to impact life insurance policies purchased after 1983. The Treasury wanted to create a clear distinction between what is considered life insurance and what is considered an investment contract.
After meeting this distinction, life insurance would retain its preferential tax benefits such as an income tax-free death benefit, income tax free cash value growth and, if structured correctly, the ability to take income tax free cash value policy loans.
The Tests for Life Insurance Compliance
Under §7702, life insurance needs to pass one of several tests:
Guideline Premium Test (“GPT”): a test focused on the premium amount and which limits the amount of premium that can be paid into a policy in order that the policy has enough death benefit risk for the amount of accumulated cash value. This is usually accomplished by limiting the amount of premium per dollar of death benefit.
Cash Value Accumulation Test (“CVAT”): a complex test that requires the cash value of a life insurance contract to not exceed certain thresholds, which are relative to the face amount of the policy. In other words, you cannot pay too much money into the policy and create too much cash value.
Seven-Pay Test: a test to determine if the life insurance contract looks too much like an investment contract. A policy cannot receive in premiums more than the total premiums necessary to pay-up a life policy within seven years.
Breaking down the changes
The Act lowered the minimum interest rates used in the calculations under §7702 for policies issued after December 31, 2020 from 4% to 2% under the CVAT test and from 6% to 4% under the GPT test. The Act did not explicitly address the 7-pay test but because the 7-pay test utilizes the same rate as CVAT, the rate used for calculating the 7-pay premium test will also change from 4% to 2%.
As previously stated, these new rates allow policyholders to put more money into a life insurance policy before a Modified Endowment Contract (“MEC”) is created. This means a policyholder should have a policy with less expense and a higher rate of return on premiums with respect to cash value.
A big deal for PPLI?
These changes could potentially be a boon to private placement life insurance (“PPLI”) where policies are typically used as a tax-shielded investment account by maximizing the amount of premium that can grow tax-deferred (or tax free if held until death). Lower interest rate calculations for §7702 and the ability to increase premiums for the same amount of death benefit means that PPLI policyholders can ‘super charge’ their outcome by putting more money into policies where it can grow untaxed.
Although some PPLI insurance companies have already incorporated the new §7702 interest rates into their available products, it will take most of the industry the rest of 2020 to re-analyze profitability, create new products, test them and file them state-by-state.
A big question on the minds of many is what the ability will be to 1035 Exchange existing whole life policies to policies utilizing the new rates where more premium could be added. What is certain is that this will take time and the industry will likely see a patchwork of different approaches to incorporating the changes, rolling out products and establishing new rules of the road.
Read our companion Tier One Interview with Barb Scoles by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.
コメント