Big Changes to Section 7702 Impact Life Insurance

While much of the focus of the federal government’s spending bills over the past year has been on economic relief, the life insurance industry got a big boost, too. With the changing of IRS Section 7702 built into the Consolidated Appropriations Act of 2021, life insurance has become more attractive to consumers. Here are what the changes did and how it affects selling life insurance.

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What the Change Is

As part of the bill signed in December 2020, life insurance companies are allowed to drop their minimum interest rate assumption on policies to 2% and 4%, depending on the policy. This calculation is used to define what a life insurance policy is.

Policies that are defined as life insurance are exempt from taxes when a death payout is made. If the policy is not defined as life insurance, then the beneficiary must pay taxes on the payout.

The History of Section 7702

Section 7702 was passed into law in 1984. Before that time, death benefits were considered tax free no matter what the policy accumulated. This meant that gains the policy earned weren’t taxed.

The problem from the IRS’ standpoint was that consumers were using life insurance policies to shelter their money from taxes, rather than using the policy for its intended purpose—as a way to provide a death benefit.

Since 1984, Section 7702 stated that gains from a life insurance policy would be taxed as normal income when the death benefit is withdrawn. The law also clearly defined life insurance policies to separate actual policies from those just feigning as one.

The Section 7702 Tests

To be considered a life insurance policy, it must pass one of two set tests. These tests are:

  • The Guideline Premium Test: It requires that any premiums paid can’t exceed a limit determined by the statute.
  • The Cash Value Accumulation Test: It requires the cash value of the policy to not exceed thresholds that are determined based on the face value of the policy.

These tests did not change at all with the Consolidated Appropriations Act of 2021. However, the interest rate assumption that’s used to calculate the limits for both premiums and cash value of life insurance policies did.

The New Rates

The interest rate assumptions hadn’t changed since Section 7702 was first enacted into law almost 40 years ago. Under the new law, those interest rates have changed. Now, for the CVAT as well as guideline level premium calculations, the new interest rate assumption is 2%. For guideline single premium calculations, the new interest rate assumption is 4%.

These rates only apply to new life insurance policies that are issued after January 1, 2021. Those policies that were issued before that date aren’t impacted at all. However, a new contract can be exchanged for the old one, with the new interest rate assumptions applied to it.

Why the Changes Were Made

The world in 1984 was significantly different than it is today. Interest rates then were very high.

It was generally assumed that life insurance policies could be credited with a 6% or at least a 4% interest over the life of that policy. Because of this, it was assumed consumers could continue to fund their life insurance policies adequately.

As interest rates went down, though, it became more challenging for these consumers to keep up their life insurance policies over the long term. With interest rates at historic lows today, it was even looking possible that particular life insurance products would go away altogether, because they just wouldn’t be attractive anymore.

For instance, the combination of interest rates that are low and the limitation on premiums could have resulted in the policy’s value being depleted well before the insured died. As a result, costs to retain the policy would increase substantially as the person aged.

What are the Practice Effects of the Changes?

The question, of course, is what are the practical effects these changes to Section 7702 will have on life insurance policies and, as a result, the life insurance industry?

Quite simply, the changes in interest rates could result in increasing the maximum amount of a policy’s premium that’s allowed to be paid into the contracts of life insurance policies. This makes life insurance policies more attractive for consumers, especially if they expect to pay higher tax rates in the future.

Life insurance policies can now, once again, become more attractive tools for people to put their money so they can enjoy growth on a tax-deferred basis. Since the policies now have the capacity to pay out more of the premium money, consumers have a better chance of avoiding having their death benefits taxed as ordinary income.

Work with an Insurance Marketing Organization

As a leading Insurance Marketing Organization (IMO), Good Life Insurance Associates (GLIA) provides a full range of insurance products, back office services, and tools to support your individual clients’ wants and needs. We provide financial advisors and insurance agents in our network across the country with access to a full range of premium carriers, expert support services, and an industry-leading compensation plan.

Contact us today to learn how we can help you establish and grow your insurance business!