Life insurance changes explained

By Jan. 1, all life insurance polices must conform to changes in IRC code 7702. Section 7702 of the Internal Revenue Service(IRS) Tax Code defines what the federal government considers to be a legitimate life insurance contract and is used to determine how proceeds are taxed.

The proceeds of policies that do not meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are tax-advantaged. Simply put, if your policy complies with the 7702 guidelines, your beneficiary does not pay taxes on the death benefit.

While this favorable tax treatment may look reasonable on its surface, problems arise when the system can be rigged, such as when other types of investment accounts are passed off as life insurance products. To prevent this from happening, Section 7702 requires life insurance contracts to pass one of two tests.

The cash value accumulation test stipulates that the cash surrender value of the contract "may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract." That means that the amount of money a policyholder could get out of the policy if they were to cancel it can't be greater than the amount that the policyholder would have paid to purchase the policy with a single lump sum.

The guideline premium and corridor test require that "the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time." This means that the policyholder can't have paid more into the policy than would be necessary to fund its insurance benefits.

A narrow but far-reaching federal tax law change tucked inside the year-end omnibus spending and coronavirus relief bill applies some new math to the interest rates used to define certain life insurance policies.

Interest rates were lowered. To make sure future benefits can be paid, premiums will be increased. The increased premiums will go directly into your cash value. This increase in cash flow to the insurance companies while allowing them to pay less interest on the cash value will enable them to operate more profitably. Participating companies will return that profit back to the policy holder in the form of dividends.

More people are using cash value life insurance policies for benefits other than death proceeds. This change while initially costing you more may make a cash value life insurance policy more desirable as a tool to accumulating money for future use like retirement planning.

The change in the code will have no effect on existing life insurance policies. It will have no effect on the cost of term insurance, except for return of premium contracts, those premiums will increase.

If your concern is low premiums then you may want to purchase a policy before the Jan. 1 deadline. I will point out many companies are implementing these new changes by Nov. 1 of this year.

If you are also concern about accumulating money for the future then these changes will benefit you.

I have said before life insurance is not an investment vehicle and should only be purchased when you have a need for a death benefit. I also believe that with our low-interest rate environment, people need ways to accumulate money by contributing monthly. With increased cash value and favorable tax treatment cash value policies may never look better.

Contact your life insurance agent and see if these changes could benefit you.