Wrapping up 2020, the IRS introduced a significant change to the tax code that governs life insurance. This code hasn’t been changed in decades, so there are bound to be adjustments going forward. While there are plenty of opinions on how this will change the industry going forward, we want to look at the facts.
The fact is, whole life insurance has over a century-long history of paying dividends in addition to the guaranteed cash value. That’s the reason insurance is a great savings vehicle—it’s certain, reliable, and better for growth than saving with the bank.
The guarantees of the life insurance company are what make policies run smoothly, and we think that the changes happening will allow guarantees to continue to be made and met. In other words, policies will continue to thrive in even the most difficult economic climates.
What is the 7702 Plan?
When we say 7702 Plan, we’re referring to a section of the IRS tax code that regulates life insurance. These regulations primarily focus on what is, and is not, life insurance, and how policies should be taxed accordingly. This section has not been changed in decades, leaving people, understandably, on edge.
The code’s original purpose was to ensure that insurance policies were not being misused as tax shelters, or in instances of money laundering. Otherwise, policy holders could fund a policy in one lump sum payment to grow tax-deferred for life and out of the reach of the IRS. So the IRS put laws in place dictating how life insurance policies could be funded and still remain life insurance.
If policies do not follow these guidelines, and are over-funded, they become Modified Endowment Contracts (MECs), and are subject to different taxation.
How is the 7702 Plan Changing?
The reason people are concerned about the changes occurring within the tax code, is due to a change in the minimum guaranteed cash value. Until recently, the cash value component of whole life insurance was based on a variable rate with a floor of 4%. This floor allowed insurance companies to calculate policy costs accurately, so that they could charge premiums that would keep policies from becoming MECs.
These guarantees have always been honored, however federal interest rates were at rock bottom last year, exposing a major problem. The IRS was still requiring insurance companies to honor the 4% floor as specified in the tax code. In other words, it was becoming unsustainable for insurance companies to continue to meet their guarantees as well as pay the non-guaranteed dividends.
(Note that the 4% floor is a gross percentage rate, which does not include policy costs. All whole life insurance illustrations portray NET cash values, after costs, regardless of whether you’re viewing the Guaranteed or Non-Guaranteed portion.)
The New MEC Limits
With some of the flaws of the previous tax code exposed, the ACLI and Finseca lobbied for changes. One such change is that MEC limits have been reevaluated, so that companies can charge higher premiums for the same face value without a policy becoming over-funded.
Higher premiums sounds like reason to take caution, though don’t go running for the hills just yet! Changing premiums allows life insurance companies to make more conservative guarantees, which is essential to navigating low-interest rate environments. With it, the IRS has lowered the guarantee floor to a gross 2%. In turn, companies can better balance their guaranteed increase with their non-guaranteed dividends.
In times of change, we look to purpose. What is the purpose of your money, or the purpose of your assets–and are they fulfilling their purposes? Premiums, while designed to cover the costs of insurance, also help you build cash value. Beyond insurance, whole life is an asset, and every dollar you put into your policy is either going toward additional cash value or your guaranteed death benefit. If the purpose of your money is to protect your legacy and grow your money with certainty, whole life insurance will still check off these boxes.
The underlying benefit of these changes is that companies will be in a better position to meet all contractual obligations in times of economic uncertainty. While guarantees may be less attractive, it also means that the non-guaranteed dividends will likely increase, especially as we move into brighter economic skies.
One of whole life insurance’s greatest features is the strength of guarantees–which no other asset class has. The Federal Reserve can continue to pump money into Wall Street, for example, however this does not eliminate the risk of the stock market.
The bottom line is that whole life insurance has proven once again that there is real strength behind it’s guarantees, and it will continue to be an asset with certainty no matter what our economy looks like.
How Will This Change Affect Your Insurance?
As the changes to the tax code begin to take effect, you likely won’t notice much change. If you’re already a policy owner, your insurance company is still required to meet the obligations of your particular contract. Existing policies will have the benefit of locking in the previous guaranteed increase, although it remains unknown how this will affect your non-guaranteed dividends.
If you do not yet have a policy, or have been considering a new policy, there’s no time like the present. You may still be able to lock in lower premiums, as it may take time for this change to take full effect. However, we still advocate for maxing out your Paid-Up Additions for faster cash value accumulation.
Other changes are harder to predict, and we like to avoid too much speculation. Just know that there will likely be some disruption in the industry as these changes take effect. The most important takeaway is to focus on what you can control, and rest assured that in the big picture, these new regulations actually strengthen the certainty of the life insurance industry as a whole.