A small, largely unnoticed, tax law change included in the 2020 year-end COVID-19 relief bill signed into law by Congress includes a significant change to the tax code. This change could be a windfall for wealthy Americans and business owners who may be considering various life insurance products as a way to shelter assets and grow their wealth on a tax-deferred basis. Here are the details.
Plunging Interest Rates Make Life Policies Unprofitable
The new legislation lowers the minimum rates of interest used to determine whether certain life insurance products are too much like investments to qualify for tax advantages granted to insurance.
This rate of interest was originally put in place back in 1984 as a way to effectively disqualify policies that were really tax-advantaged investment products masquerading as life insurance policies. But interest rates have fallen dramatically since 1984.
In fact, the U.S. life insurance industry began actually turning away business recently because record low interest rates were negatively impacting the life insurance industry’s profits.
Typically, life insurance firms hold about 70% of their general investment account in highly rated government or corporate bonds. The yields on these holdings, follow the 10-year U.S. Treasury note.
And the 10-year annual yield has been declining since the 1980s, when it peaked at nearly 16%. But the 10-year yield fell to an all-time low of less than 0.5% last year.
Without getting too deep into the details, the 1984 tax code used the assumption of a guaranteed 4% growth rate in cash value for an insurance policy to enjoy tax advantages. That rate proved to be far too high to make these policies viable as interest rates plunged to just one-half of one percent.
Under the change approved by Congress last December, the tax-code interest rate will be lowered to 2% this year and then it will be a floating rate in the future. By lowering the benchmark rate, Congress provided relief to the life insurance industry, and perhaps unwittingly, also opened the door for high-net-worth folks to put more of their money at work in the savings portion of such policies to reap the tax-deferred benefits.
The Tax Advantages
Owners of certain life insurance products, such as permanent-life policies, defer taxes on their investment gains and their beneficiaries receive the death benefit tax-free.
The recent change by Congress will generally increase the amount of money that policyholders can contribute to certain tax advantaged insurance products, such as private placement life insurance (PPLI) policies, although some restrictions remain.
This change applies to buyers of all income levels, but wealthier individuals would typically be better able to take full advantage of such policies in light of the legislative changes.
For instance, it will allow wealthier individuals to increase the amount of their investment portfolio that can be shielded from income tax through the use of such policies. The exact amount of the increase in premium deposit capacity is subject to the age of the insured. Generally, the younger you are, the greater the amount you may be able to shield in a tax advantaged policy.
Another important consideration is that there is a strong possibility Congress will enact legislation in the years ahead to increase income tax rates and decrease estate and gift exemption amounts for wealthier Americans.
In a higher tax rate environment, the combination of greater premium deposit capacity and lower cost for these policies could make them much more attractive to consider as a potentially valuable tax-deferred estate-planning option.
Finally, it’s also important to understand that traditional whole life and universal life insurance policies can become Modified Endowment Contracts (MECs) if certain premium limits are violated by the policy holder. Single-premium life insurance policies are likewise considered to be MECs.
The rules surrounding MECs were originally put in place to discourage policy holders from exploiting the very tax favorable aspects of certain life insurance products that were essentially tax-deferred investment products in disguise.
Tax Saving Professionals can help you make sense of all your tax-advantaged life insurance options in light of the recent legislative changes. To find out more, call us at (772) 257-7888.