At the end of 2020, something major happened in the life insurance industry. While there are mixed reviews for how this change will effect life insurance, we think in the long run this is a move that will allow permanent insurance policies to continue to thrive in even the most difficult economies.
As we’ve stated before, whole life insurance has a centuries-long history of paying out dividends (on top of the guaranteed cash value increase). This new change to the tax law surrounding whole life insurance will likely keep this trend going during this extremely low-interest rate environment we’re in right now.
What is Section 7702?
When we talk about the 7702 change, what we’re talking about is a change to the section of the IRS rules that govern the tax treatment of whole life insurance. This code hasn’t been changed in decades, so the news that things are changing has many people on edge.
The primary reason is because this change affects the minimum guaranteed cash value. Until now, the guaranteed increase (not dividends) was based on a variable rate that had a floor of 4%, so that insurance companies could properly calculate insurance premiums that would not be too over-funded.
A too heavily over-funded policy, called a MEC (Modified Endowment Contract), receives different tax treatment than a regular whole life policy. This is to defer insurance being misused for tax shelter purposes or money laundering.
The problem was that with rock bottom interest rates, below 1%, the IRS still required insurance companies to honor the 4% floor to follow this tax code. In order to avoid mishandling the tax code, insurance companies were offering a higher rate than was sustainable.
It should be noted that this 4% floor is a gross percentage rate, prior to any costs. All whole life insurance illustrations are presented with NET cash value (after all costs) regardless of whether you are looking at the Guaranteed Column or the Non-Guaranteed Column.
What Has Changed in the 7702 Plan?
In short, the IRS has changed the limits of what constitutes a MEC, so that companies can charge higher premiums for the same face value. While this may sound daunting, this change allows companies to make their guarantees more conservative, allowing them to better balance their non-guaranteed dividends.
It is important to remember that premiums build cash value. You are buying an asset when you buy whole life insurance, and every dollar in premium contributes to that asset either as additional cash value or guaranteed death benefit.
The real benefit is that insurance companies will better be able to weather economic uncertainties and rock bottom interest rates, while also meeting their contractual obligations. While this means guarantees may be less attractive, it also means that the non-guaranteed dividends will likely increase, especially as we move into better economic circumstances.
In other words, whole life insurance will continue to be an asset with certainty, no matter the economic forecast.
What Should You Do?
The most important takeaway is to focus on what you can control!
Moving forward, not much will change for the average consumer. If you’ve been thinking about purchasing a new policy, there’s no time like the present to do so, so you can hopefully lock in lower premiums. We still encourage maxing out your paid-up additions for maximum cash value, which your advisor can help you determine to stay within IRS guidelines.
If you already have policies in-force, know that any contractual obligations from the company must still be met. Existing policies will be grandfathered in, so not much will change unless you decide to purchase a new policy.
Any other changes are hard to predict, though we will probably see some disruption in the industry as this change begins to take place. Know what you can control, and rest assured that in the grand scheme of things, this change actually increases the certainty of the life insurance industry as a whole.
To take advantage of current premiums, or start a policy, contact us to be put in touch with a Prosperity Economics™ Advisor.