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Ta Advisory Panel Proposals Hit Inside Buildup Hard

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Proposals being advanced by a presidential advisory panel would come down hard on insurance products with tax-free inside buildup.

In one proposal, the tax-free inside buildup in life insurance and annuity products would be eliminated entirely. In the other, annual investments in life insurance and annuities would be limited to $10,000 in premiums per person.

The proposal was unveiled orally by the President’s Advisory Panel on Federal Tax Reform Oct. 18 and will be included in the panel’s written report, due Nov. 1.

It will then be evaluated by the White House and the Treasury Department, which will prepare proposals likely to be unveiled in the President’s State of the Union address before Congress in January. Then, Congress will have a stab at it. As Morgan Stanley insurance analyst Nigel Daily said in an investor’s note Oct. 19 raising alarm at the proposal, “with 2006 being an election, the likelihood for these proposals moving ahead are slim in the near term.”

The latest assault on inside buildup is being greeted with alarm by the insurance industry and analysts. Daily said in his note that the proposal “has the potential to emerge as a major new risk for the life insurance industry.

“While any action is unlikely until 2007, at the earliest, these proposals could have far-reaching repercussions for life and annuity companies, including significant reductions in the amount of life insurance sold,” he said.

Daily projected that if the tax-free buildup were eliminated, “life insurance sales, of which 77% incorporate some savings element, could come under severe pressure.”

Daily said “annuity sales could also be hit, although we expect many investors now purchase these products for the protection features rather than the tax-free buildup. The impact on pension companies is more difficult to gauge without additional details.”

The American Council of Life Insurers says it sees the advisory panel’s recommendations as “an opportunity to debate the importance of insurance protection and retirement security.”

But a top executive of a major life insurance company who has been following the issue closely for months had a different take.

First, the official said, “I am very skeptical that it will survive the process, the scrutiny of the Bush administration and then the Congress.”

However, at the same time, the official said, “This is a very, very substantial proposal, a significant event that the life insurance industry must pay close attention to.”

He also cautioned, “Overt assaults on the authors and the administration will be counterproductive. The industry must give the Treasury Department and the White House, to which the proposals will now go, the latitude to move away from this quietly.”

Specifically, the advisory panel will unveil on Nov. 1 two tax reform packages that will include one proposal to eliminate tax-free buildup in life and annuity products, and another to limit investments in these products to $10,000 in premiums annually.

One proposal will call for the government to create a “simplified income tax” system that would eliminate many tax breaks, kill the alternative minimum tax, and reduce the number of tax brackets to 3, from the current 6.

The other proposal, for a “progressive” consumption tax,” would make sweeping changes to the U.S. tax system. If the progressive consumption tax system proposal were adopted, individuals, families and sole proprietors would pay taxes only on wages and would not have to pay taxes on investment income or gains. Businesses could write off investments on equipment immediately and pay taxes mainly on cash flow.

Adoption of the proposals might eliminate many of the retirement plans, health plans and other plans now on the market, such as 401(k) plans, 529 college savings plans and the new health savings accounts.

The tax panel also wants to replace the current deduction for mortgage interest with a 15% tax credit for any mortgage interest paid. The panelists would limit eligibility for the credit to mortgages that fall within the maximum Federal Housing Administration loan limit of about $310,000.

The authors of the simplified income tax proposal would cap the employer exclusion for expenditures on group health benefits to $5,000 for individuals and $11,500 for families. The authors of the progressive consumption tax proposal would create a new tax break for purchasers of individual health coverage, but they would cap the employer exclusion at just $4,000 for individuals and $8,400 for families.

Instead, the panel will propose three new types of savings accounts. The first proposal is for “Save at Work Accounts,” which would replace 401(k)s. A second proposal is “Save for Retirement Accounts,” which would replace life and annuity tax-free buildup, IRAs, and tax-deferred compensation plans. A third plan, “Save for Families Accounts,” would replace health savings accounts, medical savings accounts, flexible spending accounts and state prepaid tuition plans.

But the life industry executive indicated that under the plans some type of grandfathering for existing life insurance and annuity policies would be created. But, he said, “the nature of these grandfather provisions is not clear.”

The overall concept behind the proposal, the insurance industry executive said, is to “establish a one-size-fits-all” program for retirement savings and protection outside employment for all sectors of the financial services industry. “But it doesn’t keep in mind that life insurance is designed not to protect the person being insured but that person’s family.

“That is a significant flaw undermining the entire process,” he added.

Jack Dolan, an ACLI spokesman, noted that, “Simplification of the tax code is important, including simplifying the many ways in which taxpayers save.”

But, he said, “it is vital to recognize that all savings are not created equal. Long-term savings, which boost Americans’ retirement security and fuel the nation’s economic growth, are more important than short-term savings.

“It will be crucial for the panel to emphasize and encourage long-term
savings,” Dolan said. “Treating all savings the same ignores human nature and the strong desire of people to have everything now. Without strong incentives, people are just likely to consume currently, which we see in the dramatic rise in credit card debt.”

Dolan said that “as the tax reform debate continues, ACLI will vigorously advocate for a tax code that strongly encourages Americans to increase their savings for the long term.”

An official at the National Association of Insurance and Financial Advisors admitted the group has been “bracing” for the report, and doesn’t see it as “good news.”

At the same time, said Jim Edwards, a NAIFA staff official, the trade group “believes that long-term savings through vehicles such as life insurance, annuities and pensions should carry an extra incentive to get people to “lock up” savings for the long haul.”

Without those incentives, Edwards said, “empirical evidence shows the vast majority of people will only ‘spend and save’–or not save at all.”

Edwards noted that the savings concepts parallel the Lifetime Savings Account proposals that President Bush recommended to Congress in his last three budget messages. “NAIFA has vehemently opposed LSAs from the outset,” he said.

The President’s Advisory Panel on Federal Tax Reform will propose three new types of savings accounts:

o “Save at Work Accounts” would replace 401(k) plans.

o “Save for Retirement Accounts” would replace life and annuity tax-free buildup, IRAs, and tax-deferred compensation plans.

o “Save for Families Accounts” would replace health savings accounts, medical savings accounts, flexible spending accounts and state prepaid tuition plans.


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