Changes to IRS Section 7702 Create an Exciting Opportunity for Life Insurance

The word “exciting” is one not usually associated with Life Insurance and an IRS code, but in 2021 that is the case. The Consolidated Appropriations Act of 2021 (HR 133) was signed into law at the end of December 2020. Most of the bill provided coronavirus relief, but there was a gift to the life insurance industry. An IRS Section 7702-rule change allows Life Insurance companies to drop the minimum interest rate assumption from 4% and 2% in their definition of life insurance calculation.

You must understand IRS Section 7702 to understand why this rule change is a big deal. Life insurance has enjoyed a favorable federal tax status in the United States since the founding with no limits until 1984. Before 1984, death benefits were paid tax-free regardless of the policy’s accumulation, and gains in the policy were not taxed. This has incentivized people to use life insurance as a tax shelter and not for the purpose of providing a death benefit.

I984 IRS Section 7702 went into law and promulgated that the gains in a life insurance contract will be taxed as ordinary income on withdrawal and established a definition of life insurance test to differentiate real life insurance policies from investment vehicles pretending to be one. The recent IRS Section 7702 rule change affects the definition of life insurance test.

Under IRS Section 7702, life insurance contracts must pass one of two tests: The cash value accumulation test (CVAT) or the guideline premium and corridor test (GPT). If a contract fails either test the death benefit, it loses its tax favorable treatment. Most insurance companies will return the excess premium to keep the contract compliant with either test. The minimum interest rate assumption since 1984 used in these tests has been 4%. That has remained unchanged despite decades of declining interests. The new minimum interest rate is now 2%.

This change in the interest rate assumption has the potential to increase the maximum amount of premium that can be paid into life insurance contracts. Taxes are likely to grow under the Biden administration. Life insurance is an attractive option for individuals looking for places to put money and enjoy tax-deferred growth. Now, life insurance will have more capacity for those premium dollars. That is exciting.