With all the drama of the year-end bill, many have overlooked the fact that it is part of a large budget bill that contains a number of tax changes. The Taxpayers Safety and Disaster Tax Relief Act of 2020 (TCDTRA) is part of the Consolidated Funds Act and includes some long-awaited changes and clarifications. One change buried deep in the law is essentially reviving a concept of retirement planning popular with some taxpayers. The core idea is that cash value life insurance can not only be used to provide an income tax-free death benefit in the event of the insured’s death, but it can also potentially be a source of tax-privileged retirement income. If the insured has accumulated sufficient present values during the years of employment and is still alive in retirement, the values represent a pool of tax-deferred dollars available to supplement retirement. In a previous post, I researched how I used this technique to supplement my own retirement savings plan, and I am encouraged that this retirement savings strategy will now be available to more Americans because of this change in the law.
What has changed?
One challenge in this low interest rate environment has been that life insurance companies have concerns about offering such products. Tax law made it difficult for these airlines because the government required them to accept interest rates that were a hypothetical four percent guarantee. I’ll save you the details, but essentially the law in the TCDTRA amends Internal Revenue Code Section 7702 which defines what qualifies as life insurance. Under the new approach, insurers can use more realistic interest rates. Ray Bening, the former chairman of FINSECA, a trading group in the life insurance industry, explains this as follows: “In order to qualify as life insurance, under the tax law, insurers had to assess premium maximums using an unrealistic return assumption. In this extremely low interest rate environment, insurance companies became concerned about the risk they would take in issuing these policies. With the new law, Congress changed the rule so that insurers can use a floating rate that starts at two percent, giving them more flexibility in setting the maximum premiums for their products. “Bening, a life insurance advisor who works with private and corporate clients, sees this tax change as a necessary solution. “Not only does it enable some innovations in pensions, it also helps companies fund their employees. It aligns tax legislation with reality, giving both insurance companies and consumers room to use premium levels that will last over the long term. ”
The growth in present value will help your retirement
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Used in retirement
M Financial Group, a major design and distribution company for financial services, is excited about this change. Devin LaPlant, Vice President Product of the M Financial Group, sees this as “consumer friendly” as product prices are adjusted to consumer behavior. “The rate change allows consumers to fund their policies sustainably, resulting in more policy stability and less risk of default in a low interest rate environment, especially given that policyholders understandably pulled their cash values during the pandemic. With this change in the definition of life insurance, there is room for more premiums and this better reflects actual returns. ”
Eric Eklund, Senior Advanced Markets Consultant at M Financial Group, also points out that although IRC 7702 was originally written in 1984 to avoid abuses in filling life insurance contracts with too much deferred taxable cash value, the interest rate has changed a lot. He sees this change in the rule in the fact that companies in low interest rates can accept more premiums and at the same time avoid abuse. “Now a policyholder can pay more premium to take into account that the insurer is at greater risk.”
There are situations for both consumer and corporate retirement planning where life insurance is a useful tool. As before, individuals often purchase life insurance to provide death benefit in the event of premature death. The advantage creates liquidity to pay off debts, cover taxes or provide survivors’ income. However, as a source of added flexibility, individuals sometimes invest enough money in their life insurance policies to create a cash reserve that can potentially be used in retirement. It’s just that the companies that issue these guidelines are now better able to offer such contracts.
Eklund points out that this offers more opportunities for lifelong planning. For example, owners sometimes finance premium costs from external sources of capital. “As this change allows the insurance company to accept more premiums, premium-funded plans will become more stable.” He also points out its application to corporate use of life insurance. Split dollar plans are a technique in which an employer pays the premiums for a cash value life insurance policy that is used as a “golden handcuff” to retain an important employee. The ability to accept more premiums in the policy makes the design of such a plan more flexible. “With split dollar plans, the idea is that the employer will get their money back at some point – and now there are more ways to make this work.”
There are a variety of cash value life insurance plans out there, and this change in tax law will affect each of these products differently. Life insurance in particular was threatened by unrealistic assumptions in IRC 7702. However, other present value designs such as universal life and variable life also had problems, adding to concerns that these policies sometimes provide means of present value access other than just retirement. The policy may have a driver providing long-term care or chronic illness benefits. The ability to accept more rewards can make these benefits more stable in the long run.
How would that work? Claudette wants life insurance and assumes that she will need it for a long time. Instead of just covering the pure risk of death by taking out risk insurance, Claudette buys a policy that develops cash values. She assumes that the additional cost of the cash value policy (compared to risk insurance) will be negligible if she dies before retirement. Your family will continue to benefit from the tax-free death benefit. If, instead, Claudette survives to retirement, she will have a reservoir of cash value that she can use to supplement her retirement income. The arcane changes to IRC 7702 mean nothing more to her than in this low interest rate environment. She will be able to bring enough premiums into her policy to make it more stable and more likely to deliver the welcome cash value in retirement.
This year it may take some time for insurers to work through the details of this legislative change and its implementation in product design. One thing is clear: this welcome change provides another tool in the toolkit for retirement.