It is ironic that 2013 marks the 100th anniversary of the income tax, because insurance industry officials are making it clear that it will be a critical one for the insurance industry.
That means that the election November 6 for the presidency, the entire House and one-third of the Senate could perhaps impact the attractiveness of the tax-advantaged products that are the lynch pin of the insurance industry for, perhaps, another century.
“In an ironic twist of historical symmetry, in 2013 the National Association of Insurance and Financial Advisors (NAIFA) will be fighting again to protect our products from a very polemically charged Washington, looking to pay down its debt,” said Robert Miller, outgoing president at the trade group’s annual meeting in Las Vegas last month. “And it’s a big one.”
Miller noted that in 1913, NAIFA’s predecessor association, the National Association of Life Underwriters, helped to carve out the tax benefits of life insurance products during the Woodrow Wilson administration. Those tax advantages are now at serious risk, Miller said.
“No matter which party members in this room belong to, there is one bandwagon you better get on today: the insurance party,” Miller said. “We are one signature from extinction—just one.”
The tax advantages Miller warned about were those that apply to a number of life insurance products and features, including inside buildup of value, corporate-owned life insurance, bank-owned life insurance, the estate tax, general federal tax rates, non-qualified deferred compensation plans and the dividend-received deductions on variable annuity contracts. All of these enjoy some kind of preferential tax treatment…for now. That could all change as the country heads toward a so-called “fiscal cliff” in January 2013, when the terms of the Budget Control Act of 2011 would kick in. This would include the expiration of Bush-era tax breaks, a larger overall tax burden for many, and deep, automatic government spending cuts in both defense and Medicare. Based on the Obama administration’s proposed 2013 budget, other provisions on the table include generation-skipping transfer taxes and grantor-retained annuity trusts.
In comments at a financial and investment roundtable in March, American Council of Life Insurers President and CEO Dirk Kempthorne added that regardless of who wins the presidential election and which party controls the House and Senate, tax expenditures would resurface in 2013 in connection with tax reform. Almost everything will be on the table, he said.
“It will be up to the industry to show that the current tax treatment of life insurance and retirement savings products that has been in place for the last 100 years should remain intact for another 100 years, “ Kempthorne said. “We must show Congress and the administration that tampering with our companies and our products is not just bad public policy, but undermines efforts to help people maintain their financial security, dignity and independence throughout their entire lives.”
In an interview with National Underwriter, Chris Morton, vice president, legislative affairs for the Association of Advanced Life Underwriters (AALU) said much the same as Kempthorne, noting that regardless of who won the White House in November, threats to the tax treatment of life insurance would persist. On both sides of the aisle, he said, there is a push to lower tax rates and broaden the tax base to simplify the tax code in a way that many feel will stimulate economic growth and provide certainty. “These are goals that everyone shares,” Morton said.
To pay for the lowering of rates, Morton explains, politicians on both sides advocate dipping into “the so-called bucket of tax expenditures.” This puts the inside build-up/cash value of life insurance policies on what the government considers to be a short list of lost revenue opportunities. The AALU, however, feels that life insurance should not be considered a tax expenditure since such products are purchased with after-tax dollars.
Morton explained that from a tax policy perspective, a tax is not imposed until there is cash to pay the tax. Just as the government would not impose a tax on the appreciation of one’s home or stock, any gain that comes from the surrender or sale of a life insurance policy should be taxed at ordinary income, and not at a preferential rate.
Underlying the concern, NAIFA has already scheduled a lobbying conference for April 2013, out of concern that Congress will be getting an early start on tax and expenditure reform.
The total impact of the so-called “fiscal cliff” was delayed for six months when the Senate, on September 22 passed legislation that extended the current budget for the 2013 fiscal year for six months.
However, the so-called “extender” only dealt with discretionary federal appropriations and $1.2 trillion in automatic spending cuts over 10 years are still due to take effect on January 1.
This would impact both entitlement and defense spending, and would likely result in a cut of government expenditures and tax hikes totaling $600 billion in 2013.
A key Republican senator has been quoted as saying that if President Obama is re-elected Republicans would have to bend to give him some tax increases in order to fend off a huge cut in defense spending. As of late September, Obama maintained as much as a seven-point lead over his opponent, Massachusetts Governor Mitt Romney.
“We might as well cut a deal,” Sen. James DeMint, R-SC. said of an Obama win. “If Republicans want to maintain the defense, we’re going to have to give tax increases to Obama.”
“When Jim DeMint is suddenly open to revenues, you know the tide is turning,” a grinning Sen. Charles Schumer, D-N.Y., responded.
The thinking is also that if Romney wins, Republicans will offer Obama a deal whereby severe cuts in Medicare and other entitlement programs will be averted in exchange for a one-year, across-the-board extension of the Bush tax cuts.
That gives Congress some breathing room to forestall the deep cuts in expenditures for the 2013 fiscal year mandated by the legislation that some feared would throw the country immediately into a deep recession.
However, the Bush tax cuts, the so-called Economic Growth and Tax Relief Reconciliation Act of 2001 (EGGTRA), expires December 31. If Congress fails to act, the tax rates in effect at the beginning of 2001 take effect. That, combined with fixing the the Alternative Minimum Tax (AMT), and dealing with tax extenders, amounts to about a $4 trillion tax increase.
By year-end, Congress will also have to decide whether to extend federal, supplemental unemployment benefits, and the current two-point cut in employees’ share of Social Security taxes.
Additionally, doctors who treat Medicare patients will take almost a 30 percent cut in the rate by which Medicare reimburses them if Congress doesn’t enact the so-called doc fix. Add another $1 trillion to the total from these issues.
And, the estate tax returns to a $1 million personal exemption and a 55 percent top tax rate.
Almost 15 million U.S. households (12.5 percent) would have a potential tax liability if Congress fails to act and the estate tax law reverts back to $1 million and 55 percent maximum tax, according to a study recently released by LIMRA, LOMA and LL Global.
“The uncertainty that has surrounded our estate tax laws has made it impossible for Americans to plan for a reasonable transition of their assets to the ones they love and to charity for the greater good,” according to Robert Kerzner, president and CEO of LIMRA, LOMA and LL Global. “Today, there are three likely possibilities that Congress could adopt—if they address this issue before the end of the year—which would impact many American families and businesses.”
Approaching the fiscal cliff
As Danea Kehoe, an outside counsel with DBK Consulting in Washington, D.C. noted at the recent NAIFA meeting, some of this could be positive. A higher tax rate on income, for example, could make the inside build-up of life insurance and annuities look more attractive. But the impact on estate tax rates, and higher tax rates on mutual funds and other financial investment options remain serious negatives.
EGTRRA made significant changes in several areas of the tax code, including income tax rates, estate and gift tax exclusions, the capital gains tax, and qualified and retirement plan rules. In general, the act lowered tax rates and simplified retirement and qualified plan rules such as for individual retirement accounts, 401(k) plans, 403(b) plans and pension plans.
The pension plan changes were made permanent in the 2006 Pension Modernization Act, and the law was extended for two years in December 2010. In that extension, estate tax provisions were extended and enlarged.
Under the legislation, the 39.6 percent bracket was gradually lowered to 35 percent by 2006 and the capital gains tax reduced from 20 percent to 15 percent.
The bill phased out the estate tax for 2010 after gradually lowering it to a per-person $3.5 million exemption and a 45 percent maximum tax rate for 2009.
Under the extension, which expires December 31, the per-person exemption is $5 million and the maximum tax rate is 35 percent. It also amended the 2001 law by providing “portability”—eliminating the complex estate planning documentation necessary to ensure that beneficiaries of estate get the benefits of a couple’s exemption. (Under the current policy, an executor of a deceased spouse’s estate is able to transfer any unused exemption to the surviving spouse without such planning.) It also restored the reunification of estate and gift taxes eliminated under the 2001 bill.
Prior to EGTRRA, the estate and gift taxes were unified, creating a single graduated rate schedule for both. That single lifetime exemption could be used for gifts and/or bequests. The EGTRRA decoupled these systems. The 2010 extension reunified the estate and gift taxes for 2011 and 2012 and indexed it for inflation effective in 2012.
It is entirely possible, given that the deadline for the “fiscal cliff” crisis has already been kicked to March 27, 2013, that Congress will punt and extend EGGTRA as is for perhaps one or two years while comprehensive tax reform is worked out in the incoming Congress.
Work has already started on that issue. The Senate Finance Committee and the House Ways and Means Committee, the key tax-writing panels in Congress, have already held joint hearings on important tax issues.
Analysts at Washington Analysis in Washington, D.C., which advises institutional investors and hedge funds, note that Congress will need to extend the current debt limit in the first quarter of 2013, if not sooner.
Washington Analysis analysts say that a GOP sweep means a near crisis like last year’s debate on the debt issue is much less probable. “If Obama wins, however, we would expect two to four debt limit fights in 2013 that could end up looking a lot like the fight in August 2011,” the analysts said.
What if Obama Wins?
What if Romney Wins?
Given that recent polls indicate that the previously predicted Republican sweep of Congress is much less likely, and that Democrats in the House could narrow the current 25-seat Republican majority in the House, an extension of the status quo ante for one or two years while Congress works on a bipartisan solution to the burgeoning debt issue is growing more likely.
As for the candidates, President Obama has proposed raising the tax on long-term capital gains from 15 percent to 20 percent. He would maintain the current rates of 0 percent and 15 percent on qualified dividends and long-term capital gain for couples earning less than $250,000.
He would maintain the 3.8 percent Medicare tax on long-term capital gains that is scheduled to take effect in 2013.
Romney proposes maintaining the 0 percent and 15 percent rates on qualified dividend and long-term capital gains. He would eliminate taxes on capital gains, dividend and interest for taxpayers with adjusted gross income below $200,000. Romney would eliminate the 3.8 percent Medicare tax on capital gains.
On income taxes, Obama proposes that couples earning more than $250,000 a year would see their rate move back to 39.6 percent after the expiration this December 31 of the Bush-era tax cuts that lowered it to 35 percent.
Romney calls for setting the highest tax rate at 25 percent and the lowest at 8 percent, down two percentage points from the current level. The plan proposed by vice presidential candidate Paul Ryan proposes a simpler plan. He calls for creating two tax rates, 10 percent and 25 percent, to replace the six that currently exist.
On tax preferences, Republicans would pay for lowering ordinary tax rates by eliminating certain deductions and credits. However, they have not said which of these would be targeted.
Democrats call for a cap of 28 percent on itemized deductions as well as on health insurance provided by employers, municipal interest, retirement plan contributions and student loan deductions and expenses for higher education.
On estate taxes, President Obama calls for raising the current estate and gift tax rates to 45 percent, with a $3.5 million per-person exemption, the 2009 level. Democrats on the House sought to hold up the December 2010 deal that was much sweeter than the 2009 levels, but, given that their ranks were decimated by the 2010 elections, finally decided to surrender and go home.