Tax Considerations for Life Insurance

Life insurance provides a number of important benefits, in addition to the financial peace of mind that it can bring to a family. But not to be forgotten are the tax advantages available as a result of investing in this form of financial protection. While the number and scope may vary depending upon the type of coverage, there are traditionally two main tax benefits enjoyed by life insurance. The first and most well-known of these is that policy proceeds (i.e., the policy death benefit) are almost always paid out to the beneficiary or beneficiaries on a tax-free basis. And the second: whole-life policies may accumulate their annual earnings tax-free until those earnings are actually distributed to the policyholder or beneficiaries.

In recent years, the interest rates paid by life insurance policies have been extremely competitive with those of other investment options. This, coupled with the aforementioned tax advantages, has had the effect of making life insurance an extremely attractive choice for those seeking a means of rapid cash accumulation in addition to the traditional financial protection that such policies provide. The U.S. Congress, however, in an effort to curtail this more non-traditional use of life insurance for quick money growth, decided to define and implement a set of criteria that all such types of policies must meet in order to qualify for and be 'classified' as life insurance, and thereby continue to be eligible for tax advantages. To receive the tax-preferred status, a policy must now meet the requirements of at least one of two tests:

The cash value accumulation test. Under this qualification, a life insurance policy's cash surrender value may never exceed the net single premium that would be required to purchase those same future benefits. Here's an example: if a $150,000 whole life policy carries a cash value of $15,000 for a 40-year-old man, in order to be eligible under this test the net single premium for this amount of coverage at the man's age must be at least $15,000. If the single premium is less than the cash surrender value, the policy will not qualify as life insurance and the tax advantages would be lost.

Guideline premium and corridor test. As the name suggests, this qualification is actually two separate tests in one. The corridor test is an evaluation of the relationship between a policy's death benefit and its cash value at any point during the life of the policy. To meet the eligibility requirement, the cash value must not be greater than a designated percentage of the policy's total death benefit. As an example, let's assume that the total death benefit for a 30-year-old policyholder cannot be less than 300 percent of the policy's cash surrender value. If the policy has a current cash value on or before the policyholder's 30th birthday of $50,000, then the policy's total death benefit must be at least $150,000. The additional $100,000 included in the death benefit is 'pure insurance,' and is known as the insurance corridor.

The second part of this qualification, the guideline premium test, considers the amount of premiums paid. To meet eligibility here, the total premiums paid for the policy must not exceed the guideline single premium (the total single premium required to purchase the policy's future benefits) or the total of the guideline level premiums (the level annual premium amount necessary to pay for the policy's future benefits, payable at least until the insured's 95th birthday), whichever is more. If the policy fails to meet the requirements of both parts of the guideline premium and corridor test, it will not be granted qualification as a life insurance product.