Life insurance is valuable to your estate plan if you plan to leave a death benefit for your loved ones. In addition, some life insurance policies offer the opportunity to accumulate cash value through an investment component.
Cash value life insurance comes in two primary forms; whole life and universal life policies. Whole Life provides standard premiums, guarantees death benefits, and holds cash value to pay the rising cost of insurance as the policy matures without increasing the premiums. Universal life policies provide flexible premium payments with a face value that funds the face value amount. IUL relies on interest credited to the policy from the chosen market index, in addition to the premiums to ensure the policy remains in force until death.
The more interest earnings available, the smaller the premiums required to provide and maintain the cash value. If lower interest earnings occur, larger premiums could be needed to maintain the coverage. The tax law requires specific interest rates be used in setting tax limits on policy premiums and cash values. The impact of COVID-19 on the already historically low-interest rates pushed the design and funding of permanent life insurance policies, which led Congress to change the existing interest rates as defined by IRS Section 7702 and 7702A.
Background of IRC Code 7702
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Section 7702 of the U.S Internal Revenue Service lays down the requirements that must be fulfilled for an insurance contract to be treated as on a contract and the amount of cash that can accumulate relative to the death benefit. The limits use actuarial calculations to determine the present value of future death benefits using the greatest of 6% or the guaranteed interest rate for guideline single premium and the higher of 4% or the guaranteed interest rate for guideline level and Modified Endowment Contracts. (flag this for plagiarism)
Policies must pass one of the cash-value accumulation tests (CVAT) and guideline premium tests (GPT) so that the cash value build-up will not be taxable. Under Section 7702A, a policy must pass through the 7-pay test so that it is not recognized as a Modified Endowment Contract. Under this test, a life policy cannot receive premiums more than the total premiums necessary to pay up a life policy within seven years.
The IRS code remains important since it dictates which types of cash value life insurance policies are eligible to receive tax advantages. If a life insurance policy does not meet the criteria listed in this section, then the growth of the cash value of the policy is taxable income to the beneficiary.
Implemented Changes in IRS Section 7702
As the market for life insurance blossomed in the last half of the 20th century, a large number of life insurance policyholders were using cash value life insurance as a tax shelter. Many policies issued before 1985 offered enormous growth potential in their cash value component, and the IRS sought to stop this by introducing section 7702 tax rules. The changing landscape of life insurance drove the need to have new laws as more people continue to rely on policies for financial security. Currently, more than half of Americans possess at least one type of life insurance, with the key motivation being saving for retirement and financial security for loved ones upon death.
Section 7702 was implemented in 1984 when interest rates were much higher compared to the current rates, with an amendment, 7702A, in 1988. At the time, it was reasonable to assume that policies would be credited with a 4-6% interest rate over the life of the policy-making it affordable for consumers to fund their policies. However, harsh economic times characterized by exceptionally low-interest rates, the mandatory interest rate assumptions for the CVAT, and GPT made it more difficult for consumers to maintain long-term life insurance coverage.
Life insurance companies pushed for these changes to continue operating a sustainable business in protecting American policyholders amidst the declining interest rates. With the drop in interest rates, insurance companies would be required to hold additional reserves. The cost of these reserves would be pushed down to the policyholders through higher premiums. Furthermore, this meant that some products would not be offered in the future. Prolonged low-interest rates, economic crises, and a dynamic healthcare environment would make it less certain for interest to be credited over the lifetime of a newly issued policy in excess of the 4% limit.
Not everything changes. The cash value corridor factors remain constant, meaning the cash value to death benefit relationship will remain the same. With the higher premium limits, this corridor limit has the potential to come into play more often.
Impact of the Change on IUL
In December 2020, Congress voted to pass the Consolidated Appropriations Act of 2021, which included further revisions to Section 7702. For life insurance contracts issued after 2021, the insurance interest rate will be predetermined only in an adjustment year, which will allow bigger front-loaded premiums for the same amount of IUL death benefits. Effective January 1, 2021, the insurance interest rate is defined as 2% and may now be used to calculate adherences for 2021. From 2022, the market-based rate calculation took effect; however, the insurance interest rate remained at 2%.
The new provision will help permanent life policies to continue being characterized as tax-advantaged life insurance contracts and avoid being classified as other investments whose benefits are considered taxable income. Even though the newer post-7702 IUL policies will accommodate more premiums, the guaranteed lifetime growth of these new policies will be compressed. As a result, more of the cash value growth will thus be tied to the determined index, and less of the total growth will be derived from the company’s guaranteed cash value trajectory within the contract.
Under the new provision, lower interest rates will slash all future IUL policies guaranteed cash value growth rate from 4% to a low of 2%. Implementing lower interest rates in the various calculations under sections 7702 and 7702A will result in increased funding limits for life insurance contracts. Premium limits calculated under the GPT and the 7-pay test have now increased. The changes to these limits are pretty substantial versus the prior limits. Similarly, using a lower interest rate to calculate the single net premium for the CVAT should produce higher cash values relative to the face amount of a contract.
Looking into the Future of IUL
The Consolidated Appropriations Act of 2021 brought about the recent amendments to code 7702, which are necessary for the sustainability of the life insurance industry. By updating the interest rates and actuarial assumptions that have been in use since the 1980s, insurance companies can now continue offering competitive products that guarantee returns to the policyholders.
It is now possible to maximize the upside potential of IULs even more. Risks will be minimized further by offering IULs the opportunity for growth on larger premiums. As the new changes take effect, life insurance policies will remain a relevant and viable tool not only at the death of the policyholder but also for tax-free income streams that can be generated during their lifetime.
As IULs continue to grow in popularity, understanding the effects of the new changes on these policies might confuse many people with existing policies. Optimizing your IUL to reap the most benefits requires seasoned expertise in the insurance industry. At Ogletree Financial, our licensed experts will help you understand the impact of the new interest rates on your existing and new policies. Call us today to receive your quote from the top-rated carriers in the country.
FAQs About the Changes to 7702 on IUL
Since insurance companies were at the forefront of pushing for the reforms of the existing interest rates, all IUL products issued from January 2021 were in line with the new changes.
No. Your existing policy will not use the new rules; hence, the interest rate parameters and premium limits will be based on the old law. Although some carriers are allowing retroactive 7702 interest rate changes, the new rules apply to contracts from 2021.
Possibly, it depends on your situation. We should talk first. Many insured with older policies are finding it makes sense to roll into a new policy. Before making a decision we need to run an analysis on your current policy vs. the new policy and see what would be best for you.