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Taxing life insurance benefits would be bad—up to a point

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The growing chorus among the nation’s political elite for closing so-called “tax expenditures” or loopholes as part of a bipartisan tax-reform package have placed the tax-favored status of life insurance squarely within Congress’ cross-hairs. Not surprisingly, Congressional-watchers within our industry are sounding the alarm, warning of the threat that eliminating or restricting such preferential treatment would pose.

Impact on the industry

Clearly, if life insurance policyholders could no longer claim the tax benefits they now enjoy—income tax-free death benefits and tax-deferral of the cash value component of permanent life insurance policies—the products would be less attractive from a tax perspective. Lest you doubt this assertion, consider the negative impact of past changes to the tax code.

Time and again, IRC restrictions on one or another life insurance-funded advanced planning technique has forced advisors and their clients to consider alternative solutions for achieving financial goals. Example: IRS regulations finalized in 2003, which dampened enthusiasm for a once popular strategy, equity collateral assignment split-dollar plans, as a vehicle for funding non-qualified executive compensation.

Employer-funded premium payments into these executive comp plans are now treated as a series of “loans” to the employee. Assuming (as is usually the case) the loan is governed by below market loan rules, then the loan is characterized as one bearing interest, subject to the applicable federal rate (AFR). And this “foregone interest” is taxable.

Key employees thus now must pay a tax on a previously tax-free fringe benefit: their share (or equity) of a policy’s cash value. For this reason, sources say, the 2003 regs chilled businesses’ interest in loan regime plans used in executive comp planning.

The chilling effect would undoubtedly be all the greater if Congress were to water down or eliminate the tax-favored treatment of the inside build-up in employer-owned life insurance—a much discussed item in Congress’ target list of tax expenditures. And if all cash value policies—EOLI or otherwise—were no longer accorded tax-preferential status, then the chilling could lead to a deep freeze in permanent life insurance sales.

To be more precise, the drop off in sales would extend to a sector of a market most coveted by life insurance and financial service professionals: high net worth individuals and businesses owners who value the products as a tax play in investment planning, business planning and estate/wealth transfer planning. For the affluent, life insurance is simply one asset class among many—mutual funds, ETFs, emerging market stocks, commodities, real estate investment trusts, among others—to be considered when designing a portfolio. Take away the tax-preferential treatment on the inside build-up, and affluent investors might decide to reallocate the insurance component of the portfolio to other asset classes.

How changes to tax policies enter into the calculus of high net worth individuals when deciding whether to buy life insurance was explored in a June 2011 paper, “Who Responds to Tax Reforms? Evidence from the Life Insurance Market.” The report, based on an earlier German (SAVE) study, discussed the impact on the life insurance market of a 2005 income tax reform in Germany. For decades, the report notes, endowment life insurance—contracts payable to insured individuals if they are still living on a policy’s maturity date; or otherwise payable to the beneficiary—was a best seller in Germany. Between 1975 and 1990, the policies accounted for about 60% of newly written individual life insurance contracts.

Key reason: The products long enjoyed special tax treatment. For endowment insurance contracts completed as late 2004, the report observes, premium payments were partially tax-deductible as “special expenses” up to a threshold that varied by marital status and type of employment. Additionally, insurance benefits were fully tax-exempt if, among other qualifying requirements, the policyholder was older than 60 at the maturity date and the contract had been in force for 12 years.

When Germany’s Retirement Income Act went into effect on January 1, 2005, however, the legislation eliminated the special tax treatment. Lump sum insurance benefits in the policies are now subject to the personal income tax of policyholders if they’re under age 60; otherwise, half of the taxable insurance earnings are subject to income tax.

Result: The Retirement Income Act “severely compromised the financial attractiveness” of the policies among one of two groups examined in the study: well-informed, above-average earning and opportunity-seeking households. Less educated and lower-income households, in contrast, tended to be less influenced by the tax policy changes, buying the contracts for non-tax-related product features, such as coverage of dependents or investment in a low-risk asset.

A broader shift

Judging by the comments of two insurance professionals who spoke at a Prudential Financial media briefing on October 17, clients’ focus on non-tax considerations is becoming more widespread—including among the affluent. The presenters, Stephanie Sherman and George Barnes, both Prudential-affiliated financial planners, noted a “shift” in the marketplace since the downturn of 2007-2009.

Because, they said, outperforming the stock market is more challenging given the current volatility of equities and uncertain economic climate, clients are now more interested in policy guarantees than in tax benefits that might boost one’s return on investment.

This change in focus is as it should be. The primary function of life insurance is, after all, to replace income and otherwise satisfy the liquidity needs of beneficiaries in the event of an insured’s death. To the extent that policies can help meet secondary investment, retirement, business or wealth transfer planning objectives, all the better.

If life insurance professionals and their clients can keep this order of priorities in mind, then perhaps they would be less concerned about the vicissitudes of tax policy. For the nation’s tax code will always be in flux, but the need for life insurance will remain a constant.


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