Shifts in the Economy Prompt Changes to Decades-Old Life Insurance Tax Code

In December 2020, Section 7702 of the U.S. Internal Revenue Code IRS tax code was amended, resulting in the first major change to the tax code since 1984.

If you’re not familiar with it, Section 7702 was created specifically to differentiate between a genuine life insurance policy and investment vehicles imitating life insurance contracts. The main objective of Section 7702 is to ensure that only legitimate life insurance policies receive tax-advantaged treatment. It also defines just how much tax-free money is permitted to accumulate inside a permanent life insurance policy.

Simply put, Section 7702 determines whether a life insurance contract actually qualifies for tax benefits and how proceeds from a life insurance policy are to be taxed.[1] If a contract fails to meet the government’s definition of a legitimate life insurance policy, any proceeds from the policy will be considered taxable as ordinary income — whether money is withdrawn from the policy or not.[2]

What has changed? 

The amendments to Section 7702 will now permit certain life insurance policies to build cash value up to an established limit and in proportion to the policy premiums paid, before the IRS considers the policy a modified endowment contract and taxes it accordingly. For policy owners, this change will allow them to put more cash into the savings portion of permanent life policies.

According to the Wall Street Journal, U.S. House staff report that the changes to Section 7702 were necessary “to reflect economic realities” and provide consumers “access to financial security via permanent life-insurance policies.”

To be more reflective of current economic conditions and low interest rates, Section 7702 has also changed the guaranteed insurance rate for the cash value accumulation in permanent life insurance policies from 4% to 2% for this year, and will use a variable rate moving forward.

Conclusion

In general, the overall consensus is that amendments made to Section 7702 will provide benefits to the industry as well as consumers, helping stabilize the life insurance industry amid historically low interest rates and making permanent life insurance more attractive to the public.   

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[1] IRS.gov.
[2] Investopedia.

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