Defining Life Insurance
The Federal Government sought to define what Life Insurance was with the Deficit Reduction Act of 1984 (DEFRA), which defined life insurance for income tax purposes as “an amount at risk.”
The law states that a beneficiary is entitled to all of the income tax benefits of a life insurance policy. However, if the policy fails the seven pay test, then it may not be deemed a life insurance policy and all of the income tax benefits would be eliminated.
The IRS has two different tests to determine if a policy qualifies as “life insurance” under Internal Revenue Code Section 7702.
- Cash value accumulation test, or
- Meet the guideline premium requirements, and fall within the cash value corridor of Internal Revenue Code Section 7702.
Cash Value Accumulation Test
A life insurance contract meets the cash value accumulation test if, in the terms of the contract, the cash surrender value of the contract does not at any point exceed the net single premium that would be paid to fund benefits under the contract. Many people like to use the cash value accumulation test because it deals with the cash value and not the premiums paid. This is a good option if you are planning fund your flexible premium policy to the max.
Guideline Premium Test
A life insurance contract meets the guideline premium requirements if the total premiums paid do not exceed the guideline premium at any time in the present or the future. This test consists of two principles: the guideline single premium and the guideline level premium. The IRS states that the guideline premium limitation as of any date is the greater of the guideline single premium or the sum of the guideline level premiums to that date.
The guideline single premium is the premium that would be required on the date the contract is issued to fund the future benefits under the contract, based on reasonable mortality charges and fees and an interest rate of 6% (or the rate specified in the life insurance contract).
The guideline level premium is the level amount payable over a period which ends when the insured has reached age 95, using an interest rate of 4%. Internal Revenue Code 7702 is important because it helps us truly define life insurance.
Tax Traps to Avoid: Modified Endowment Contract, or MEC