Until 1982 no statutory rule existed that defined the characteristics of life insurance for federal tax purposes. However, in the early 1980s, Congress was motivated to act by the development of a new generation of Universal Life contracts because these new products provided significantly more cash-value build-up than was needed to support the death beneﬁt.
Life Insurance Innovation
The late 1970s and early 1980s saw two new products introduced: Universal Life and Variable Universal Life. These new products differed greatly from Whole Life as these new products:
• Paid close attention to a market rate of interest.
• Did not follow the traditional relationship of cash value and death beneﬁt.
• They allowed discretion in the timing and amount of premiums.
• With VUL, they allowed an investment strategy within the life insurance policy.
By removing the linkage between the cash value and death beneﬁt, it created the potential that a client could pay a very large premium for a relatively small amount of insurance coverage. This lead Congress to enact new laws around life insurance taxation.
TEFRA (Tax Equity and Fiscal Responsibility Act)
In response to UL contracts, Congress enacted TEFRA, or the Tax Equity and Fiscal Responsibility act of 1982. This new act loosely deﬁned a limited class of products called ﬂexible premium life insurance contracts, and it sought to deny life insurance tax treatment to contracts speciﬁcally used for investment purposes. TEFRA was speciﬁcally written as a temporary act pending a more comprehensive solution in the future.
Deﬁcit Reduction Act
Congress enacted section 7702 of the Internal Revenue Code as part of the Deﬁcit Reduction Act Of 1984 also known as DEFRA. Section 7702 restricts life insurance tax treatment to those contracts that provide at least a speciﬁed minimum amount of pure insurance protection in relation to the cash value of the contract. This act essentially shut down what Congress considered an abusive use of the tax code by using life insurance taxation for policies that were exclusively set up as an investment only.
Tax Reform Act of 1986
The Tax Reform Act of 1986 was a key piece of the Reagan administration’s proposal for a broader tax base by proposing that the build up of cash-values within a life insurance policy would be taxable. As we all know now, that portion of the proposal was not implemented. One of the greatest positive impacts of the act was it closed down many of the other tax-favored investments and tax-shelters, which left other tax-advantaged products untouched - speciﬁcally life insurance. As a result of this legislation, carriers began experiencing a signiﬁcant growth in single premium products, and some even promoted the fact that life insurance was the last great “tax-shelter” available, much to the dismay of Congress. These aggressive marketing efforts led Congress to further enact laws which resulted in the deﬁnition of a Modiﬁed Endowment Contract, as well as rules restricting the mortality and expense charges allowed in computing the required limits.
Technical and Miscellaneous Revenue Act
In 1988, Congress substantially modiﬁed the tax code even further with the introduction of the Technical and Miscellaneous Revenue Act of 1988, also known as TAMRA, which provides us with Section 7702(a) of the Internal Revenue Code. Section 7702(a) basically states that if a policy is not properly structured and funded, all of the favorable tax treatment is lost. To be properly funded and structured the policy must meet the 7-pay test. If the policy fails to meet this test, the policy is considered a Modiﬁed Endowment Contract or a MEC. By itself a MEC is not bad, it is just treated differently from a tax perspective. A downside to owning a MEC, is that if your client is planning to use the policy to withdraw income in the future, distribution of gains from a MEC are taxed and if under age 59½ a 10% tax penalty applies. Generally speaking, if you understand how a non-qualiﬁed annuity is treated from a tax perspective, you understand how a MEC is treated for tax purposes.
Know the Codes
Understanding the way life insurance tax codes work will help you maximize your clients' retirement savings. An indexed universal life (IUL) policy can help your clients avoid market losses and receive tax-free income distributions. When constructing a retirement plan, consider if an IUL policy is right for your clients. Please keep in mind that the primary reason to purchase a life insurance product is the death benefit.
Discover the six strategies of selling IUL to increase your production and help more clients avoid market losses.