Section 7702 Reform: What it Means for You and Your Life Insurance
Something surprising happened in the final days of 2020...
The Consolidated Appropriations Act, 2021 not only brought relief to millions of Americans by providing $600 checks, but it also was a blessing for the life insurance industry.
The act reformed Section 7702 of the Internal Revenue Code that defines life insurance for tax purposes.
This article explains how the changes to Section 7702 of the IRS tax code will impact the life insurance industry and how you can benefit.
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What is Section 7702 of the Tax Code?
Section 7702 of the IRS tax code outlines the definition of a life insurance contract as determined by the U.S. government and specifies the proceeds’ taxation.
In other words, the tax limitations in 7702 set the premium levels so that a life insurance policy will stay “in force,” or active, given the policy charges and the interest crediting rate. It’s the value that provides the basis for:
- Cash Value Accumulation Test (CVAT) corridor limits. Essentially, the sum of funds a policyholder could receive from a canceled contract (the cash value component) can never exceed the amount the policyholder has paid for the policy (excluding fees).
- Guaranteed Premium Test (GPT). This test determines if a policy can be taxed as an investment or life insurance contract. Test limits stipulate that only so much money can be contributed to a policy relative to the death benefit.
- Modified Endowment Contract (MEC) premium limits. Paying too much too soon into a life insurance policy can result in a policy being declared a MEC, which may take away the tax benefits of a permanent life insurance policy.
Section 7702 Reform
As interest rates have fallen over the last 40 years, these previously mandated interest rates have caused real problems, especially for companies selling whole life insurance. The Consolidated Appropriations Act changed the interest rate to 2% in 2021 and a floating interest rate after that.
As a result of the change, life insurance companies will have much more flexibility in pricing whole life contracts.
As for universal life products, the maximum non-MEC premium increases dramatically. Policyholders between the ages of 40 and 55 will be able to put in 100% to 60% more premium without creating a MEC contract.
What Does the Section 7702 Reform Mean for Insurance Companies?
Because of some of the obstacles posed by the tax code’s previous stipulations, many insurance companies will welcome this change with open arms. However, business won’t move forward as usual.
This reform will require insurance companies to make several changes. First, due to the nature of this change, insurance companies are now required to perform several activities, including:
- Perform portfolio analysis
- Determine if current products need to be revamped to meet customer needs
- Verify if current products must be refiled with state insurance departments
Some carriers have the technology to react quickly, while others will take time. Some insurers will come out with new products as others tweak the old ones.
What Does the Section 7702 Reform Mean for You?
So, what does this mean for you?
Before the reform, life insurance policies with a cash value accumulation element faced the potential consequences of being categorized as a MEC. This meant that whole life, universal life, and other types of permanent life insurance could be subject to the MEC rule.
These policies allow policyholders to tap into their contract’s cash value via a loan or partial surrender, which is distributed on a tax-deferred basis.
But, if the contract was declared a MEC, tax consequences could apply when taking a distribution. The policyholder could also end up having to pay penalties on the policy.
While MECs still have tax advantages, distributions can be subject to a tax on the amount the money in the policy has grown. And, if a policyholder is under the age of 59 1/2, they are subject to a 10% penalty, similar to what you would find with traditional individual retirement accounts or 401(k)s.
Before the Consolidated Appropriations Act passed in December, the limitations of life insurance contracts made them less attractive to consumers, specifically single premium policies (life insurance policies that are paid in full at the time of purchase).
Fast forward to the reform of 2020, and the increase to the limitations has made life insurance a more attractive vessel for savers. Because, with these changes, there will be more money in the contract relative to the cost of the life insurance.
This creates a surplus of cash that will accumulate overtime. Additionally, there will be less commission to agents per dollar of premium, making life insurance even more efficient. The long-term internal rate of return could increase by 0.5% to 1% on maximally funded contracts.
The Reform Isn’t Advantageous for Everyone
While the reform has increased the limits on the amount one can put in a policy while salvaging the tax advantages, investing in life insurance isn’t the right move for everyone.
If you’re considering a new policy but wonder if a life insurance policy is the best place to put your money, there are many factors that will help you find the right answer.
But, in general, life insurance isn’t the best investment choice for the average working class. On the other hand, our agents only advise the ultra-wealthy (those who make over 300k a year) to purchase life insurance as an investment, despite most professionals advising clients to steer clear altogether.
The issue is not that life insurance is a poor investment. Rather, it’s that most consumers don’t understand that it is one. While most agents will highlight the upside to the investment, there are risks just like any other investment. If you don’t completely understand the risk and reward of investing in a policy, you’re signing up for a dangerous endeavor.
Therefore, high-net-worth individuals may benefit the most from the recent reform. If you fall into this category, now might be the perfect time to reassess your estate plan and determine if you need to purchase a life insurance contract to capitalize on the limit increase.
When the dust settles and consumers and insurers adapt to the new changes, the industry will not only be stronger, but the consumer will be offered more efficient products. If you have turned your nose up at permanent life insurance because of the MEC rule in the past, taking another look now is worth considering.
And if you need additional guidance, our independent agents can help you identify all of the options available. A competent, independent agent who can provide a proficient level of consultancy and shop multiple carries is the key to comparing and purchasing any type of life insurance.
Above all, be extremely cautious when considering investment strategies with life insurance. If you’re looking for support, give us a call today, Toll-Free 855-247-9555, and one of our agents will be happy to show you all of your options.
Louis Lopes, CLU ChFC
Chartered Life Underwriter, Licensed Life and Health Agent
Louis has been in the insurance business for over 30 years. He specializes in “high risk” cases as well as more complex coverages for long term care, disability, and estate planning.