Defending your life: Tax reform and the inside buildup

As a vehicle intended to manage the financial risk of death and the perils of old age, life insurance is unique. With no known exception, our legislators and regulators support the critical role life insurance plays in the financial security of Americans.

NAIFA points out that life insurance accounts for 20 percent of the long-term savings for the United States and provides financial security for 75 million Americans. The manufacture, distribution and administration of life insurance and annuity products provides employment for millions of Americans. The life insurance industry pays out benefits totaling $1.5 billion per day. To put this $1.5 billion per day in perspective, all Social Security programs — combined — pay out $1.9 billion each day. Going forward, life insurance benefits will provide funding for critical and chronic long-term care, reducing the financial strain borne by Medicaid and charities.

Currently, the federal budget is badly out of balance, and in the absence of vigorous economic growth, new sources of revenue and spending reductions are needed. In this environment, a stampede of tax reform proposals could threaten key time-honored tax provisions — including those affecting life insurance.

How concerned should we be? As of now (late December 2012), there are apparently no new proposals or serious discussion suggesting specific changes to the established taxation of life insurance, but it is clear that everything is on the table. There are periodic challenges to life insurance, most recently the 2005 Report of the President’s Advisory Panel on Federal Tax Reform, which mischaracterized and exaggerated the tax treatment of life insurance (“nearly unlimited tax-free savings”) and recommended that it be limited.

See also: Life insurance among top tax breaks

The Congressional Joint Committee on Taxation (JCT) has, for many years, classified the exclusion of the inside buildup as a major tax expenditure. Tax expenditures are “revenue losses attributable to provisions of the federal tax laws, which allow a special exclusion, exemption or deduction from gross income or which provide a special credit, a preferential rate of tax or a deferral of tax liability.”

For fiscal year 2014, exclusion of the inside buildup of insurance products was reported by JCT as foregone revenue of some $29.1 billion, ranking it No. 13 on a list of approximately 200 identified tax expenditures. The $29.1 billion includes both life insurance and annuities. Of this, $27.7 billion is attributed to individual taxpayers and the remainder to corporations. To a revenue-starved Congress, this may be a tempting target.

The trouble with taxing inside buildup

Congress regularly revisits life insurance taxation and has legislated regular “course corrections” (in 1982, 1984, 1986, 1988, 2003, etc.). In developing IRC §7702 and §7702A, Congress set reasonable limits and practices that allow the industry to prosper but curbed practices Congress found excessive. Other course corrections occur at the state level, through changes in non-forfeiture regulations. For example, the shift to the 2001 Commissioners Standard Ordinary (CSO) mortality tables reduced modified endowment contract (MEC) limits. The result has been an evolving “safe harbor” that defines where Congress draws the line on what it considers outside the pale of normal taxation. These changes can harm specific types of sales and add great complexity to products, but they were not threats to the existence of life insurance. The deferral of taxation on the inside buildup, however, is existential. Without it, the product would be unaffordable and unavailable.

The Congressional Research Service (CRS) provides research and advice to Congress on budget matters. Specific to life insurance, it stated in March 2012’s The Challenge of Individual Income Tax Reform: An Economic Analysis of Tax Base Broadening:

"The exclusion of inside buildup ... can be determined actuarially, but the individual taxpayer does not actually receive the income. Consequently, changing the tax treatment would require taxation on an accrual basis rather than on a realization basis. The extent to which this might cause cash flow difficulties for the investor depends on how large the annuity appreciation is relative to other income. [...] A withholding tax could be imposed on the insurance company, and the taxpayer could take a credit for it, much as is done with wage withholding. It would add complexity to the tax form, however.”

CRS does not endorse taxing the inside buildup, and it identifies the critical reason why this is integral to the operation of a policy: policy earnings cannot be removed. Otherwise, the policy will fail in its principal purpose. It is therefore not constructively received. This tax treatment has been in effect since the very beginnings of the permanent federal income tax system 100 years ago. This was validated in U.S. tax court (in Cohen vs. Comm., 39 TC 1055 [1961]) for cash-basis taxpayers and again (in Nesbitt v. Comm., 43 TC 629 [1965]) for accrual taxpayers.

See also: The life insurance fiscal cliff: The end of a tax-preferred product class?

Nor is this deferral unique to life insurance and annuities. A cash-basis taxpayer does not declare year-by-year gains on real estate or other types of property until a gain is actually realized.

To generate the estimated $29.1 billion in FY 2014, every current in-force policy would be administered under two types of tax accounting: interest earned under the old system would be treated differently than interest earned in future years.

Alternately, the new law could apply only to new policies going forward and not to in-force policies. If so, it would take decades before revenue on the scale of $29.1 billion could be generated.

How would the taxation work?

For an existential threat, very little is known about how this concept would actually work and how much revenue it would actually produce. The current Internal Revenue Code provides little guidance. There’s only one situation in which deferral is denied — a punitive form of taxation applied to policies that have failed the definition of life insurance. Under IRC 7702(g)(1)(B) through (D), ordinary income “received or accrued” is the difference between each year’s premium paid and the increase in cash value, increased by the cost of mortality charges. Worse, if a contract ceases to qualify as life insurance at any point, “income ... for all prior taxable years shall be treated as received or accrued during the taxable year in which such cessation occurs.” (IRC 7702(g)(1)(C)).

Because of the wide variety of life insurance products, accurately defining “earnings on the premiums” could be very challenging. A whole life policy has a guaranteed cash value that represents interest minus charges for mortality and loading. The year-by-year change in guaranteed cash value is not entirely “earnings,” so reporting could be confusing, especially if interest credited is greater than the increase in cash value.

See also: Washington regulation: 6 things to look for in 2013

Variable life insurance policies may increase or decrease in value. Presumably, a loss would be disallowed, making the tax unfairly disproportionate. There might be a system to carry-forward losses to offset future gains, but administration would be challenging. Also, “earnings” in a variable policy may be based on interest or changes to unit values of equity-based units, possibly requiring additional calculations.

Secondary guarantee universal life insurance policies have an account value (on which interest is credited to finance the cost of the secondary guarantee) as well as a cash value net of these charges. Typically, there is little or no surrender value, but pre-tax interest earnings finance the benefit. It would be disastrous to apply the tax on an account value that has scant relation to surrender value.

At this early stage, there have already been suggestions to generate revenue by limiting itemized deductions and tax-advantaged income. Under that concept, each taxpayer would be able to choose from a broad list, such as employer-paid health insurance or mortgage interest deductions or charitable deductions, subject to a limit.

The cap on deductions and preferences concept is vulnerable to unforeseen consequences that could distort vital markets. Is “free” health insurance really comparable to tax-free municipal bond income? If the market is distorted, what are the consequences for market supply? Where would long-term savings and death risk management fit among taxpayer preferences? Is it practical to expect each taxpayer to keep permanent records of what portion of life insurance or annuity was sheltered and what portion was not?

Upon careful examination, the way life insurance is taxed reflects its long-term nature and is logical and time-honored. Clearly, it would become less affordable if designed to spin off income to pay for annual taxation of cash value. At this time, it’s important to remember NAIFA, SFP and other organizations are dedicated to communicating with Congressional staffers who have the power to write such legislation. The way to fiscal stability is through growth, and the life insurance and annuity industries fuel growth by fostering personal responsibility, financial durability and community development.

 

For more on taxes, see:

What the fiscal cliff compromise means for your clients' taxes

Industry girds for next tax battle

Battleplans

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