Cash value life insurance vs. term insurance/investment combinations.

• Author: Jackson, George

Frequently, accountants assist in designing personal financial plans that include term life insurance, cash value insurance or a combination of the two.(1) In such instances, two basic questions should be asked: First, how much insurance protection and how much cash value does the individual need? Second, given that some level of life insurance protection and cash value is needed, should the individual purchase a. life insurance policy that includes cash value (a universal life policy, for example), or is it preferable to purchase less expensive term insurance and build cash value outside the policy (i.e., purchase an annuity)?

The accountant's unique contribution to financial planning is integrating tax issues into the overall financial plan. This article will describe the income tax treatment of life insurance versus an alternative investment, and present a method of analysis that assists the insured in reaching an optimal solution to the second question. It is assumed that the individual desires a combination that provides the desired level of protection and the highest after-tax cash value(2) for a given number of dollars invested. There is no attempt to prescribe how much insurance or how much cash value one needs.

Universal life is used as the cash value insurance example in this article. It typically combines a constant amount of life insurance coverage plus a cash value that increases over time, and, on a before-tax basis, is identical to a term insurance policy combined with an outside investment. An annuity contract is used as the outside investment (since it builds cash value in a manner similar to life insurance) and enjoys some of the tax deferral benefits of life insurance. Moreover, since many insurance companies offer both products, the two are frequently marketed as alternative ways of building cash value. Other combinations can be analyzed using the methodology presented. For example, a traditional whole life policy has a constant death benefit and can be compared to a decreasing term policy plus an annuity.

Excluded from discussion are the various types of principal-qualified annuities(3) recognized by Sec. 403, and "modified endowment" life insurance policies under Sec. 7702A. Although they appear under a variety of titles, the common thread for qualified annuities is that, within narrow limits prescribed by the Code, an investment in the contract is currently deductible. A qualified plan almost always produces a higher after-tax cash accumulation than a nonqualified plan and therefore is not considered. This article will focus on the taxpayer who is not eligible for a qualified plan or has a planning need in excess of the maximum amount eligible for qualified plan treatment.

A modified endowment contract qualifies as life insurance under Sec. 7702. But because it fails the "7-pay" test set out in Sec. 7702A(b), it loses the favorable income tax treatment applicable to other types of life insurance for withdrawals before death. Usually, the policy serves more as a vehicle for building cash value than as a means of providing financial security in the event of an untimely death, and it is taxed in a manner similar to qualified savings plans. Because of these differences the modified endowment contract requires a separate analysis, and is not discussed further.

Definitions

It is important to define precisely a life insurance policy and an annuity because of the differing tax treatment each receives. Sec. 7702(a) defines a life insurance contract for tax purposes as any contract that qualifies as a life insurance or endowment contract under applicable state law, and meets either

--a cash value accumulation test, or

--a two-tiered test involving a "guideline premium" test and a "cash value corridor" criterion.

Under the cash value accumulation test, a contract is life insurance if the cash surrender value at no time exceeds the net single premium that would be required to fund all future benefits payable to the beneficiary under the terms of the contract.(4)

Applicable interest rates, mortality assumptions and other variables to be used in making this calculation either are Code specified or there is a reasonableness requirement. Pure term life insurance has no cash value and thus always meets the cash value accumulation test.

To qualify under the second alternative test, the contract must first meet "guideline premium requirements,"(5) which mandate that the sum of premiums actually paid on a policy at any point may not exceed the greater of (1) the single premium necessary to fund all future benefits under the policy or (2) the sum of required annual level premiums that would be payable assuming the taxpayer were to make annual payments until age 95. As in the cash value accumulation test, the Code specifies certain assumptions that must be made in calculating these guideline premiums.

In addition, under the second alternative test, the policy must fall within a "cash value corridor" that compares death benefits to cash surrender values.(6) For example, a policy on an insured age 46 must have a death benefit no less than 215% of the cash surrender value. As the taxpayer grows older, the minimum percentage drops. At age 50, for example, the minimum death benefit is 185% of cash value. A loan against a life insurance policy is not mentioned in the tests for a life insurance policy previously discussed. Therefore, a loan has no impact on whether the policy qualifies as life insurance.

Neither the Code nor the regulations contain a definition of an annuity. The regulations describe the term by referring to accepted usage in the insurance industry. Regs. Sec. 1.72-2(a)(1) states that Sec. 72 applies to contracts that are considered to be life insurance, endowment or annuity contracts under the customary practice of life insurance companies. It is widely agreed that an annuity consists of periodic investments that earn tax-deferred income. The investment is eventually surrendered and income is recognized at that point.(7) The essential distinction between insurance and an annuity is that the life contingency inherent in life insurance contracts is either eliminated or becomes substantially less important for an annuity.

Tax Issues

There are a number of income tax issues that must be considered when recommending a cash value life insurance policy or a term policy plus an annuity.

* Death benefits

A life insurance death benefit (including any cash value paid) is not included in taxable income. An annuity benefit paid at death is taxable to the extent it exceeds the investment in the annuity contract. Therefore, if the policy is held until death, cash value insurance has a tax advantage over the term/annuity combination.

* Investment in the contract

The investment in the cash value policy is the sum of all premiums paid. These premiums include amounts implicitly paid for insurance protection and the amounts paid for cash value. The investment in the term/annuity combination is the sum of the premiums paid for the annuity...