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Small Tax Change Makes Big Impact on Permanent Life Insurance

January 28, 2021
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Typically, when Congress passes a bill, it has many additional items in the small print that can be quite impactful. Late in December 2020, federal lawmakers’ gigantic year-end spending package included a barely noticed tax code revision which is of enormous benefit to those who have, or are planning to purchase, permanent life insurance (Source: Wall Street Journal, 2021).

Life insurance is one of the most profoundly beneficial financial planning tools that money can buy. Life Insurance transfers financial risk upon death (i.e. loss of income, future earning potential, loss of benefits, and more), off of an individual, and onto the financial institution that holds your life insurance policy. It has many tax advantages to other financial products, and it is a cornerstone of a balanced estate.

There are two types of life insurance of which you may be aware: term life insurance and permanent life insurance.

Term Life Insurance

Term life insurance is often the most affordable option and it is limited by a specific amount of time—the term of your policy—be it 20, 30 years, etc. You make your payments to the policy on a regular basis, either monthly or annually. The price is fixed for the policy and during that term, you immediately have built an estate for yourself upon death, which is equal to the death benefit you purchased with your policy. The stated policy’s death benefit is transferred to the policy beneficiaries income tax-free. If you do not pass away during the term, the policy expires, and other than having insured yourself in case of the worst-case scenario, you will not receive further benefit at the end of the term.

Permanent Life Insurance

Permanent life insurance is a different beast—and it is the beneficiary of the recent tax code changes, for which you should be aware.

Permanent life insurance includes Whole Life Policies and Universal Life Policies. These two options are typically more expensive than term life insurance. Once purchased, as long as premiums are paid according to your payment schedule, these policies last the duration of your life. You make your payments to the policy on a regular basis, either monthly or annually. The price is fixed for the policy and upon its inception, you immediately have built an estate for yourself upon death, which is equal to the death benefit you purchased with your policy. Whole life insurance builds up a cash value inside of the policy, while universal life insurance generally does not. Owners of permanent life insurance policies defer the taxes on their investment gains inside of the policy, and their stated beneficiaries receive the death benefit income tax-free. Choosing a whole life insurance policy is usually based on the benefits your estate is looking for, and the amount of premium that you can afford. However, once in place, the policy does not expire.

Many things have changed in insurance since the 1980s, including interest rates. Life insurance is an estate planning tool—quite powerful, indeed. In 1984, Congress sought to identify investment products disguised as life insurance, as life insurance receives a favorable tax treatment. They hoped to find policyholders who were stuffing large sums of money into these tax-advantageous policies, in hopes of bypassing tax billings from the government. In this rule—Section 7702—the 1984 tax code adopted an assumption of a guaranteed 4% growth rate in cash value for a permanent life insurance policy to enjoy its tax advantages.

As you may be aware, the life insurance world has changed substantially- not only in the types of products available for consumers, but also in the interest rate environments in which these policies have resided in, since the 1980s. This 4% assumption has been particularly problematic for whole life insurance policies, which is a very popular type of policy for middle class families and small business owners—the bedrock of America.

Life insurers earn part of their profits by investing customer’s premiums until they are needed for a payout. Many profitable life insurance companies are heavily invested in high-quality bonds. These portfolio yields peaked in the 1980s at nearly 16%, whereas the 10-year Treasury yield is currently just over 1%.

After the recent pandemic-related promise of continued low interest rates, life insurance trade groups lobbied Congress to switch that floating interest rate, saying that without the change, whole life insurance policies would likely go extinct. This law lowers the minimum interest rate used to determine whether combination savings and death benefit policies inside of permanent life insurance are too much like investments to qualify for the tax advantages granted to insurance.

Because of this rule change, companies that offer these policies are likely to continue to offer permanent life insurance policies, and this lowered threat to such products is likely to lead to a resurgence in quality permanent life insurance options, with greater benefits for consumers who want to take advantage of one the most powerful financial vehicles available.

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