Cash Value Life Insurance & IRS Guidelines
Tax-free status
Because cash value life insurance makes an appealing, tax-free investment (particularly universal life insurance), the Internal Revenue Service restricts the maximum investment allowed in a policy. Life insurance is still a desirable investment, but your policy must abide by certain “guidelines” to maintain its tax-advantaged status. (*Because term life insurance generally has no cash value account, it is largely exempt from the following considerations.)
Internal Revenue Code restrictions:
There are two ways for a life insurance contract to legally qualify as such (and therefore enjoy tax advantages):
- Satisfy the cash value accumulation test (or)
- Satisfy the guideline premium requirements and cash value corridor
If your policy fails both of these, it becomes taxable like any other investment.
Cash value accumulation test
At any time, the single net premium required to fund future benefits must exceed your cash surrender value*. That is, if you were to pay off the entire remaining cost of your policy so that you would never need to pay again, the premium payment in question must be greater than your current cash surrender value.
Guideline premium requirements
The guideline single premium and the guideline level premium are values which approximate the cost of the policy. The sum of your premium payments is never to exceed both of these guidelines (you may exceed one or the other, however).
Your agent can calculate both of these guidelines for you.
**HINT** Accessing cash value: policy loans vs. withdrawals
Because of the limits on premiums, policy loans may be preferable to withdrawals, if you intend to pay back the money. Payments against a policy loan are not considered premiums and so do not concern the premium guidelines.
Cash value corridor
The cash value corridor dictates that your death benefit must not be less than a certain percentage of your cash surrender value. In simpler terms:
death benefit ≥ X% of cash value
(where X is drawn from a tax table based on age)If you are under 40, your death benefit must be at least 2½ times as great as your cash surrender value (i.e. 250%). At age 95, your death benefit must be at least equal to your cash value (i.e. 100%).
TEFRA restrictions
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) also imposes limitations. Your insurance agent can compute the following guidelines for you as they pertain to your policy.
Single premium guideline
Not to be confused with the guideline single premium motioned above, this represents a maximum amount that you may pay in aggregate premiums during the first seven years of your policy.
Failure to abide by this regulation will void your policy’s tax-advantaged status, most notably, your death benefit’s exemption from income tax.
7-pay premium guideline
This guideline represents the maximum amount that may be contributed in premiums annually. Remaining allowance, not used in a given year, rolls over to increase future allowance.
If the 7-pay premium guideline is broken, your policy is treated as a modified endowment contract (MEC) for taxation purposes. This means that access to your cash value will be taxed as a gain first and as costs basis last (instead of accessing it tax-free until you reach your cost basis).
Level premium guideline
Following the level premium guideline (not to be confused with the guideline level premium already discussed) will ensure that you remain in accordance with both of the previous two guidelines. Unlike the other so-called “guidelines” represented here, the level premium guideline really is just a guide to help you. Your policy suffers no adverse consequences if you do not abide by it.
*The IRC defines "cash surrender value" as the cash value of your policy without regard to surrender charges.
This page simplifies concepts beyond what some circumstances may warrant. This page is not intended to replace legal counsel or personal perusal of the tax code.
Information represented in this section is drawn from Title 26 § 7702 of the Internal Revenue Code
