Cash value life insurance vs. term insurance/investment combinations.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 annuity: see insurance. annuity Payment made at a fixed interval. A common example is the payment received by retirees from their pension plan. There are two main classes of annuities: annuities certain and contingent annuities. )? The accountant's unique contribution to financial planning Financial planning Evaluating the investing and financing options available to a firm. Planning includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in the form of a financial plan, and then comparing future performance against 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 The person who obtains or is otherwise covered by insurance on his or her health, life, or property. The insured in a policy is not limited to the insured named in the policy but applies to anyone who is insured under the policy. insured n. 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 af·ter-tax also af·ter·tax adj. Relating to or being that which remains after payment, especially of income taxes: after-tax profits. cash value(2) for a given number of dollars invested. There is no attempt to prescribe pre·scribe v. To give directions, either orally or in writing, for the preparation and administration of a remedy to be used in the treatment of a disease. 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 Annuity Contract The written agreement between an insurance company and a customer outlining each party's obligations in an annuity coverage agreement. This document will include the specific details of the contract, such as the structure of the annuity (variable or fixed), any 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 tax deferral The delay of a tax liability until a future date. For example, an IRA may result in a tax deferral on the amount contributed to the IRA and on any income earned on funds in the IRA until withdrawals are made. 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 an·a·lyze tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es 1. To examine methodically by separating into parts and studying their interrelations. 2. Chemistry To make a chemical analysis of. 3. 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 mod·i·fy v. mod·i·fied, mod·i·fy·ing, mod·i·fies v.tr. 1. To change in form or character; alter. 2. endowment A transfer, generally as a gift, of money or property to an institution for a particular purpose. The bestowal of money as a permanent fund, the income of which is to be used for the benefit of a charity, college, or other institution. " 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 pre·scribe v. pre·scribed, pre·scrib·ing, pre·scribes v.tr. 1. To set down as a rule or guide; enjoin. See Synonyms at dictate. 2. To order the use of (a medicine or other treatment). by the Code, an investment in the contract is currently deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). . A qualified plan almost always produces a higher after-tax cash accumulation Accumulation 1) In the context of individual investing, it is the process of contributing cash to invest in securities over a period of time in order to build a portfolio of desired value. Dividends and capital gains are also reinvested during this process. than a nonqualified plan Nonqualified plan A retirement plan that does not meet the IRS requirements for favorable tax treatment. 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 fa·vor·a·ble adj. 1. Advantageous; helpful: favorable winds. 2. Encouraging; propitious: a favorable diagnosis. 3. 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 guideline Medtalk A series of recommendations by a body of experts in a particular discipline. See Cancer screening guidelines, Cardiac profile guidelines, Gatekeeper guidelines, Harvard guidelines, Transfusion guidelines. premium" test and a "cash value corridor" criterion
Under the cash value accumulation test, a contract is life insurance if the cash surrender value The amount of money that an insurance company pays the insured upon cancellation of a life insurance policy before death and which is a specific figure assigned to the policy at that particular time, reduced by a charge for administrative expenses. at no time exceeds the net single premium that would be required to fund all future benefits payable to the beneficiary beneficiary Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. 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 spec·i·fy tr.v. spec·i·fied, spec·i·fy·ing, spec·i·fies 1. To state explicitly or in detail: specified the amount needed. 2. To include in a specification. 3. 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 A judicial command, order, or precept, written or oral, from a court; a direction that a court has the authority to give and an individual is bound to obey. A mandate might be issued upon the decision of an appeal, which directs that a particular action be taken, or upon a 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 Tax-deferred income Dividends, interest, and unrealized capital gains on investments in an account such as a qualified retirement plan, where income is not subject to taxation until a withdrawal is made. . 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 contingency n. an event that might not occur. 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 Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . 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 im·plic·it adj. 1. Implied or understood though not directly expressed: an implicit agreement not to raise the touchy subject. 2. 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 only.(8) Therefore, a cash value life insurance policy has an income tax advantage because its investment exceeds the term/annuity investment by the amount of premiums paid for term insurance. * Taxation of investment income Income earned, but not distributed by either a cash value life insurance policy or an annuity, is tax deferred. When cash is withdrawn, income earned may be subject to tax. The taxable amount depends on whether the withdrawal (1) is from life insurance or an annuity, (2) is periodic or non-periodic or (3) occurs before or after the annuity starting date Annuity starting date The date when an annuitant starts receiving payments from an annuity. . When cash is withdrawn, life insurance may be favored in very limited circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or . (*) Early withdrawal penalty If a withdrawal is made from a cash value life insurance contract at any age, the cash proceeds in excess of the investment in the contract are taxed as ordinary income. If a withdrawal is made from an annuity contract before the owner reaches age 59 1/2, the cash proceeds in excess of the investment in the contract are taxed as ordinary income and under Sec. 72(q) an additional 10% penalty. tax is imposed. After age 59 1/2 there is no penalty tax. Therefore, a cash value life insurance policy may have two tax advantages over an annuity in this respect. First, taxable income generated from the withdrawal of cash value from a life insurance contract is smaller because of the differences in the bases of the investment contracts. Second, the tax rate on the withdrawal of the cash value from a life insurance contract may be smaller because of the penalty tax on the annuity. * Loans A life insurance policy or an annuity contract may permit borrowing against cash value without canceling the contract. A loan against a life insurance policy that does not exceed the investment in the contract has no immediate tax consequence. Any loan against an annuity contract(9) triggers income recognition until all income earned on the contract has been taxed. Therefore, a cash value life insurance policy has a tax advantage in this respect. As set out above, a cash value insurance policy enjoys more favorable tax attributes than an annuity because (1) it is not taxable at death, (2) it generates comparable amounts of economic income with less taxable income, (3) it is taxed at a lower rate on early withdrawal and (4) a limited amount of cash value can be withdrawn from an insurance policy without current tax consequences. A disadvantage In policy debate, a disadvantage (abbreviated as DA, and sometimes referred to as a Disad) is an argument that a team brings up against a policy action that is being considered. Structure A DA usually has four key elements. of a cash value policy is that expensive insurance coverage is required to maintain favorable tax attributes of the policy when insurance coverage in excess of the cash value is no longer needed. When the cash value of the annuity portion of a term/annuity combination is sufficient to meet the needs of the insured, the term insurance can be dropped with no negative tax consequences. Therefore, a life insurance policy has a tax advantage, but may have an economic disadvantage. This suggests that given the assumptions of economically ec·o·nom·i·cal adj. 1. Prudent and thrifty in management; not wasteful or extravagant. See Synonyms at sparing. 2. Intended to save money, as by efficient operation or elimination of unnecessary features; economic: equivalent policies (i.e., before tax costs tax costs n. a motion to contest a claim for court costs submitted by a prevailing party in a lawsuit. It is called a "Motion to Tax Costs" and asks the judge to deny or reduce claimed costs. for insurance and cash accumulations are equal), life insurance may be a superior investment in the short term, but the term/annuity combination may be a superior investment after life insurance protection is no longer needed. Resulting Tax Consequences The relevant tax issues already discussed are expanded on through examples based on the following fact scenario A scenario (from Italian, that which is pinned to the scenery) is a synthetic description of an event or series of actions and events. In the Commedia dell'arte , taken from the life insurance and annuity tables on page 527-528. * Facts P, a 37-year-old male, is in the 28% income tax bracket Noun 1. income tax bracket - a category of taxpayers based on the amount of their income income bracket, tax bracket bracket - a category falling within certain defined limits . He wishes to purchase $250,000 of insurance protection, build maximum cash value and make total premium payments of $4,000 annually until he reaches retirement at age 60. P has decided that at age 60 insurance protection will no longer be needed because the accumulated ac·cu·mu·late v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates v.tr. To gather or pile up; amass. See Synonyms at gather. v.intr. To mount up; increase. cash value of the policy will be sufficient to cover planning needs. There are two alternatives under consideration. The first is to use the entire premium to purchase cash value life insurance. The second is to purchase a term policy/annuity combination: a portion of the $4,000 premium is used to purchase a term policy and the balance is invested in an income-deferred annuity. Neither investment option yields a current deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. , but income earned by both alternatives is tax deferred. If the pretax pre·tax adj. Existing before tax deductions: pretax income. pretax adj [profit] → vor (Abzug der) Steuern cash values are equal, the tax attributes of the competing policies can be examined in isolation.(10) Therefore, the examples that follow use a cash value insurance policy and a term/annuity combination that are economically identical except for the tax treatment of each at withdrawal or death.
Life Term/
insurance annuity
Total premium payments
to age 60:
Mortality or term charges $24,501 $24,501
Investment 67,499 67,499
Total premiums 92,000 92,000
Cash and death benefits
at age 60 before tax:(11)
Cash value 194,354 194,354
Life insurance 250,000 250,000
Total insurance &
cash value $444,354 $444,354
* Death benefits A life insurance death benefit (including any cash value paid as a death benefit) is not taxable under Sec. 101(a), while the portion of the cash that flows from an annuity in excess of the investment is taxable under Sec. 72. Since the investment in the annuity is $67,499, taxable income of $126,855 ($194,354 -- $67,499) is recognized when the annuity is paid. Example 1: P dies at age 60. His heirs collect $444,354 under either policy. The after-tax effects for the two alternatives are:
Life Term/
insurance annuity
Cash value $194,354 $194,354
Life insurance 250,000 250,000
Total insurance &
cash value 444,354 444,354
Tax paid 0 35,519
After-tax proceeds $444,354 $408,835
(*) Tax is paid on the interest earned on the annuity as follows:
Value of annuity at age 60 $194,354
Investment in the annuity 67,499
Interest income
from annuity 126,855
Tax rate 0.28
Taxes paid $35,519
* Investment in the contract All amounts invested in a cash value life insurance policy are added to the investment in the contract as defined in Sec. 72(c)(1) and (e)(6). These amounts include the premiums implicitly paid for insurance protection (mortality charge) and the premiums implicitly paid for cash value. With a term/annuity combination, only the amount actually invested in the annuity is added to the investment in the contract.(12) Amounts paid for term insurance protection do not build investment. This means that the investment in the cash value life insurance policy is always higher than the investment in an annuity policy and will result in less taxable gain Taxable Gain The portion of a sale that is liable to taxation. Notes: When redistributing mutual fund shares that have increased in value, returns may be subject to taxation. See also: Capital gain, Income Tax on ultimate receipt (whether receipt comes before or after death). Example 2: P's investment in the two alternative policies is:
Life Term/
insurance annuity
Mortality or term charges $24,501 $24,501
Implicit investment 67,499 67,499
Total premium 92,000 92,000
Investment in contract $92,000 $67,499
* Taxation of investment income Income earned, but not distributed by either a cash value life insurance policy or a term/annuity combination, is tax deferred until the income is withdrawn. When a withdrawal occurs, however, the amount of taxable income depends on whether the withdrawal is (1) regular or irregular HEIR, IRREGULAR. In Louisiana, irregular heirs are those who are neither testamentary nor legal, and who have been established by law to take the succession. See Civ. Code of Lo. art. 874. ,(13) (2) before or after the annuity starting date and (3) from life insurance or an annuity.(14) Irregular distributions after the maturity date: Any irregular distribution of life insurance cash value received on or after the annuity starting date is taxable once all investment in the contract has been recovered (FIFO (First In First Out) A storage method that retrieves the item stored for the longest time. Contrast with LIFO. See traffic engineering methods. FIFO - first-in first-out rule).(15) Any irregular distribution under an annuity contract received on or after the annuity starting date is fully taxable,(16) unless it is in the nature of a full refund TO REFUND. To pay back by the party who has received it, to the party who has paid it, money which ought not to have been paid. 2. On a deficiency of assets, executors and administrators cum testamento annexo, are entitled to have refunded to them legacies , surrender To give up, return, or yield. The word surrender presupposes the possession or ownership of the thing that is to be returned or given up. It indicates a transfer of title as well as possession, but it does not express or in any way suggest the transaction of a sale , redemption The liberation of an estate in real property from a mortgage. Redemption is the process by which land that has been mortgaged or pledged is bought back or reclaimed. It is accomplished through a payment of the debt owed or a fulfillment of the other conditions. or maturity that permits application of the FIFO rule.(17) Example 3: After the maturity date, P receives an irregular distribution of $50,000 from the policy, which has a cash value of $120,000, an investment of $80,000 and resulting interest income of $40,000. The after-tax effects for the two alternatives are:
Life Term/
insurance annuity
Cash receipt $50,000 $50,000
Capital recovery 50,000 0
Taxable income 0 50,000
Tax (28%) 0 14,000
After-tax proceeds $50,000 $36,000
This example leads to the perverse per·verse adj. 1. Directed away from what is right or good; perverted. 2. Obstinately persisting in an error or fault; wrongly self-willed or stubborn. 3. a. result that there is $50,000 of taxable income, but only $40,000 of economic income for the term/annuity combination. This $10,000 of additional taxable income is eventually recovered. First, if the annuity ceases by reason of the annuitant's death, the $10,000 unrecovered investment ($80,000 investment in the contract -- $70,000 remaining fair market value (FMV FMV - full-motion video )) is deducted de·duct v. de·duct·ed, de·duct·ing, de·ducts v.tr. 1. To take away (a quantity) from another; subtract. 2. To derive by deduction; deduce. v.intr. by the annuitant Annuitant 1. A person who receives the benefits of an annuity or pension. 2. The person upon whom a life-insurance contract is based. Notes: 1. In other words, the annuitant is the beneficiary of an annuity or pension. 2. in the year of death.(18) Second, if the annuity ceases for any other reason, the $10,000 unrecovered investment ($80,000 investment in the contract -- $70,000 remaining FMV) is a capital loss.(19) Although the correct amount of income is eventually taxed, the taxpayer wants to avoid this possibility, since there is current income but a deferred deduction. An example of a full refund, surrender, etc. is not given because the entire $40,000 of income would be taxable income for both life insurance and the annuity under the FIFO rule. Irregular distributions before the maturity date: The tax rules differ for an irregular series of distributions before the policy maturity date of cash value life insurance or an annuity.(20) Cash value life insurance has a substantial advantage over an annuity in this regard: * Irregular distributions before the maturity date (life insurance). An irregular distribution of cash value of life insurance received before the maturity date is tax free until the investment in the contract has been fully recovered under a FIFO rule. Once the investment is recovered, any excess is fully taxed.(21) * Irregular distributions before the maturity date (annuity). An irregular distribution of cash value of an annuity received before the maturity date is fully taxed until all income has been recovered under a LIFO (Last In-First Out) A queueing method in which the next item to be retrieved is the item most recently placed in the queue. Contrast with FIFO. LIFO - stack rule. When all income has been recovered, the investment is then recovered tax free under the recovery of capital doctrine In United States tax law the recovery of capital doctrine protects a portion of investment receipts from being taxed, namely the amount that was initially invested. This is because the investor is receiving his or her own money, which is being returned to him or her. .(22) Example 4: Before the maturity date, P receives an irregular distribution of $50,000 from the policy, which has a cash value of $120,000, an investment of $80,000 and resulting interest income of $40,000. The after-tax effects for the two alternatives are:
Life Term/
insurance annuity
Cash receipt $50,000 $50,000
Capital recovery 50,000 10,000
Taxable income 0 40,000
Tax (28%) 0 11,200
After-tax proceeds
(cash -- tax) 50,000 $38,800
Regular distributions after the maturity date: Regular distributions (as opposed op·pose v. op·posed, op·pos·ing, op·pos·es v.tr. 1. To be in contention or conflict with: oppose the enemy force. 2. to a lump sum Lump sum A large one-time payment of money. or irregular series of distributions) from an insurance policy or an annuity are taxed identically, except that the bases of the policies are different. Sec. 72(b)(1) excludes from taxable income that part of any amount received that bears the same ratio to such amount as the investment in the contract bears to the expected return Expected Return The average of a probability distribution of possible returns, calculated by using the following formula: under the contract. The portion of a receipt that represents the original investment in the contract is not taxable; the portion that represents investment income is taxable. Example 5: At age 60 P receives $50,000 in annuity payments during a year. Expected cash receipts are $500,000. The after-tax effects for the two alternatives are:
Life Term/
insurance annuity
Mortality or term charges $24,501 $24,501
Implicit investment 67,499 67,499
Total premium 92,000 92,000
Investment in contract 92,000 67,499
Cash receipt 50,000 50,000
Inclusion ratio 0.816(*) 0.865(**)
Taxable income 40,800 43,250
Tax (28%) 11,424 12,110
After-tax proceeds
(cash-tax) $38,576 $37,890
(*)[1- ($92,000/$500,000)].
(**)[1- ($67,499/$500,000)].
Regular distributions before the maturity date: Regular distributions by definition occur after the maturity date of the policy. Therefore, there are no regular distributions before the maturity date. * Early withdrawal penalty If a withdrawal is made from a cash value life insurance contract at any age, any income recognized is taxed at ordinary rates. If a withdrawal is made from an annuity contract before the insured reaches age 59 1/2, any income recognized is taxed at ordinary rates plus a 10% penalty tax.(23) Accordingly, the cash value life insurance policy has a substantial advantage over an annuity. Example 6: P's policy matures at age 59. P receives a regular $50,000 distribution and expected cash receipts are $500,000. The after-tax effects for the two alternatives are:
Life Term/
insurance annuity
Mortality or term charges $22,263 $22,263
Implicit investment 65,737 65,737
Total premium 88,000 88,000
Investment in contract 88,000 65,737
Cash receipt 50,000 50,000
Inclusion ratio 0.824(*) 0.869(**)
Taxable income 41,200 43,450
Tax [28%; (28% + 10%),
respectively] 11,536 16,511
After-tax proceeds
(cash -- tax) $38,464 $33,489
(*) [1 - $88,000/$500,000)].
(**) [1 - $65,737/$500,000)].
The difference in tax is reconciled rec·on·cile v. rec·on·ciled, rec·on·cil·ing, rec·on·ciles v.tr. 1. To reestablish a close relationship between. 2. To settle or resolve. 3. as follows:
Difference in taxable income
($2,250 x 0.28) $630
Difference in tax rates
($43,450 x 0.10) 4,345
Total difference in tax $4,975
* Loans A life insurance policy may permit the insured to borrow Borrow To obtain or receive money on loan with the promise or understanding that it will be repaid. against the cash value without canceling the contract. The result is that cash value, up to the investment in the contract, may be withdrawn from the policy with no current tax consequence under Sec. 72(e)(5). (This is the FIFO rule discussed in the section, "Taxation of investment income.") There are two potential disadvantages of borrowing against life insurance. First, insurance protection must be maintained (when it may not be needed) to keep the tax advantages of life insurance. Second, there are substantial limitations on the deductibility of the interest paid on the loan even when the proceeds are used for trade or business, investment, personal residence, etc.(24) If a loan is still outstanding at death, the loan amount is ignored for tax purposes because death benefits from a life insurance policy are not taxable. An annuity may also permit borrowing against cash value without cancellation cancellation (See: cancel) CANCELLATION. Its general acceptation, is the act of crossing a writing; it is used sometimes to signify the manual operation of tearing or destroying the instrument itself. Hyde v. Hyde, 1 Eq. Cas. Abr. 409; Rob. . However, for annuity contracts entered into after Aug. 13, 1982,(25) withdrawals result in income recognition until all cash value in excess of the investment in the contract has been recovered. (This is the LIFO rule discussed in the section, "Taxation of investment income.") An annuity clearly has a major tax disadvantage when compared to a cash value life insurance policy in this regard. The example of a loan against a cash value policy or an annuity is identical to Example 4. Optimal After-tax Choice The fact scenario in the examples is now used to illustrate how the tax and economic issues involved in the choice between a cash value life insurance policy and a term/annuity combination interact Interact can refer to:
Fall of Interact While the Game Boy device was first released, Interact acquired the rights to sell Datel's Action Replay and when the optimal decision changes from one choice to the other. Refer to the annuity table on pages 527-528, which covers the insured, P, from age 38 through 94. There are two basic ways that cash can be withdrawn from a policy. First, the cash value can be received while the insured is living. Second, the cash value can be received at the death of the insured. Either of these basic withdrawal options may occur at any age of the insured. * Possibility 1: the policy is surrendered during the insured's lifetime. As set out in the table, from ages 38-40, if the policy is surrendered during the lifetime of the insured, term insurance plus an annuity is preferred because life insurance builds cash value slowly in the early years. From ages 41-64, there are two reasons that a cash value life insurance policy is preferred. First, the investment in the cash value insurance policy includes the total premiums paid (life insurance plus the investment) and is larger than the investment in the annuity (investment only, no life insurance). Since the investment in the life insurance is higher (see Example 2), the taxes are lower, and after-tax receipts are higher. Second, before age 59 1/2, the interest income from the annuity has a 10% penalty tax imposed (see Example 6). Beginning at age 65, term insurance plus an annuity is preferred if the policy is surrendered during the lifetime of the insured; the cash value life insurance policy has a cumulative implicit mortality charge (relevant after-insurance protection is no longer needed) that more than offsets the tax advantages of the policy. The mortality charge is required to retain the positive tax advantages of life insurance, but is wasted since the policy is surrendered before death. * Possibility 2: the policy matures at the death of the insured. For the scenario used throughout the article, from ages 38-41, if the cash value plus death benefit is received because of the death of the insured, term insurance plus an annuity is preferred because life insurance builds cash value slowly in the early years. From ages 42-91, the cash value life insurance policy is preferred because any amount (death benefit or cash value) received as the result of death from a life insurance policy is tax free, while the annuity portion of the term/annuity combination is taxed (see Example 1). The tax savings of the cash value life insurance policy plus the death benefits outweigh out·weigh tr.v. out·weighed, out·weigh·ing, out·weighs 1. To weigh more than. 2. To be more significant than; exceed in value or importance: The benefits outweigh the risks. the cumulative implicit mortality charges that are required to retain the positive tax advantages of life insurance. Beginning at age 92, term insurance plus an annuity is preferred because the cumulative implicit mortality charges of life insurance outweigh the tax savings of the cash value life insurance policy plus the death benefits received. * Strategies for making the optimal choice A general method for making the optimal after-tax choice for policies that are economically identical is set out below. 1. Compare the quality of insurance and investment companies involved. In general, lower quality firms are more risky and may offer lower premiums and/or and/or conj. Used to indicate that either or both of the items connected by it are involved. Usage Note: And/or is widely used in legal and business writing. -higher returns. Given the importance of the investment and dollars involved, a top quality company is required and only highly rated firms should be considered. 2. Recommend the amount of insurance coverage and cash value that is needed. Recommending the amount of insurance coverage and cash value needed is approximately ap·prox·i·mate adj. 1. Almost exact or correct: the approximate time of the accident. 2. equivalent to recommending the amount of monthly premium to pay. 3. Recommend the cash value policy that will give the highest rate of return over time. The highest rate of return is equivalent to the highest cash value for the premium invested. Do not recommend the policy with the highest rate of return quotation QUOTATION, practice. The allegation of some authority or case, or passage of some law, in support of a position which it is desired to establish. 2. Quotations when properly made, assist the reader, but when misplaced, they are inconvenient. , but rather recommend the policy from an insurance company that has demonstrated quality performance. 4. Recommend the term policy that gives the required insurance protection for the lowest premium in the long term. Recommending the lowest premium in the long term requires comparing the present value of competing premiums. The insured must also be confident that the term policy chosen guarantees coverage for the number of years that insurance is needed without medical requalification. For example, an annual renewable term policy usually guarantees coverage until age 75, a 20-year level-term policy guarantees coverage for 20 years, but a five-year level-term policy guarantees coverage for only five years. Subsequent years require medical exams. Therefore, an insurance company bears much more risk in an annual renewable policy and, as a result, the present value of the premiums is higher than for a five-year level term policy. 5. Recommend the income-deferred annuity that will give the highest rate of return over time, given the risk the insured is willing to assume. The amount that is invested in the annuity (Column 4 of the annuity table) is the difference between the cash value insurance premium (Column 2) and the term insurance premium (Column 3). Interest is compounded on the annuity (Column 5) each year at the rate the annuity is projected to earn. 6. Calculate the after-tax cash value of the annuity (Column 7) and the after-tax cash value of the life insurance policy (Column 10) each year. Recommend the higher value. 7. Calculate the after-tax death benefit (cash value plus insurance protection) of the term/annuity combination (Column 8) and the after-tax death benefit of the life insurance policy (Column 11) each year. Recommend the higher value. 8. Based on the results from steps 6 and 7, the insured can decide whether a term/annuity combination or a cash value policy should be purchased if the insured surrenders the policy (Column 12) at a particular age or if the insured dies (Column 13) at a particular age. Conclusion In comparing the similarities and differences between cash value life insurance and a term/annuity combination from a tax perspective, the following conclusions can be drawn. In general, if the policy is surrendered before death, the annuity is preferred in the very short term because the life insurance policy initially builds cash value slowly. After the first few years, the Years, The the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109] See : Time life insurance policy is preferred because the higher investment in the life insurance results in lower taxes, in spite of in opposition to all efforts of; in defiance or contempt of; notwithstanding. See also: Spite the fact that the before-tax cash values are relatively equal. At some point, typically a few years after retirement, the annuity is preferred because the implicit cumulative mortality charges have reached a point at which they exceed the tax advantages of the life insurance policy. Similarly, if the policy matures because of death, the annuity is preferred in the very short term. After the first few years, the life insurance policy is preferred because none of the life insurance proceeds is taxed, while the annuity proceeds from the term/annuity combination are taxed. If the insured survives to an unusually old age, the annuity is again preferred because the implicit cumulative mortality charges have reached a point where they exceed the sum of the tax advantages of the life insurance policy plus the death benefit. The general results set out above should hold true for other types of policies, but there could be some variation based on amounts invested, interest rates, implicit mortality charges, term charges, age at the inception INCEPTION. The commencement; the beginning. In making a will, for example, the writing is its inception. 3 Co. 31 b; Plowd. 343. Vide Consummation; Progression. of the policy, etc. (1) Term life insurance pays a specified amount if the insured dies, but builds no cash value. Cash value insurance includes term protection plus a savings component. For either type of policy, the owner implicitly or explicitly ex·plic·it adj. 1. a. Fully and clearly expressed; leaving nothing implied. b. Fully and clearly defined or formulated: "generalizations that are powerful, precise, and explicit" pays a mortality charge which increases as the insured grows older, and a charge to cover administrative expenses and profit. See, e.g., Droms and Baldwin Baldwin, cities, United States Baldwin. 1 Uninc. city (1990 pop. 22,719), Nassau co., SE N.Y., on the south shore of Long Island, on Baldwin Bay; settled 1640s. A fishing center and summer resort, it has varied manufactures. , "Evaluating the Investment Merits The strict legal rights of the parties to a lawsuit. The word merits refers to the substance of a legal dispute and not the technicalities that can affect a lawsuit. A judgment on the merits is the final resolution of a particular dispute. MERITS. of Life Insurance," 167 Journal of Accountancy 63 (May 1989). (2) There are vastly different amounts of risk associated with different types of insurance policies. This article does not address the relative risk of insurance companies or the relative risk of particular types of policies. Instead, the tax attributes of competing policies are analyzed, given that the insured has chosen a level of risk (company and policy). (3) An annuity can be principal qualified and/or income qualified. Investment in a principal-qualified annuity (individual retirement account (IRA Ira, in the Bible Ira (ī`rə), in the Bible. 1 Chief officer of David. 2, 3 Two of David's guard. IRA, abbreviation IRA. ), qualified retirement plan, etc.) results in current deductions against taxable income or exclusions exclusions, n.pl the dental services not covered under a dental benefits program. from income. Investment in an income-qualified annuity (nondeductible non·de·duct·i·ble adj. Not deductible, especially for income-tax purposes. Adj. 1. nondeductible - not allowable as a deduction deductible - acceptable as a deduction (especially as a tax deduction) IRA, qualified retirement plan, etc.) results in no current deduction against taxable income or exclusion exclusion /ex·clu·sion/ (eks-kloo´zhun) 1. a shutting out or elimination. 2. surgical isolation of a part, as of a segment of intestine, without removal from the body. from income for the investment, but income earned by the investment is tax deferred. (4) Sec. 7702(b)(1). (5) Sec. 7702(c). (6) Sec. 7702(d). (7) See, e.g., Tax Facts 1 (National Underwriting Underwriting 1. The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt). 2. The process of issuing insurance policies. Company, 1991), at 1. (8) The investment in a tax-deferred annuity tax-deferred annuity See tax-sheltered annuity (TSA). is zero, so the annuity is fully taxed when received. (9) Any loan against an annuity contract entered into after Aug. 13, 1982 triggers income under Sec. 72(e)(4) and (5)(B). Any loan against an annuity contract entered into before Aug. 14, 1982 is treated the same as a loan against life insurance. (10) The assumed rate of return on the annuity (7.537423%) was chosen so that the $194,353 pretax cash value of the annuity and the $193,353 pretax cash value of the life insurance policy are equal when P retires at age 60. Based on their individual experiences and conversations with insurance professionals, the authors believe this is a realistic assumption. (11) This is a universal life policy, which includes the cash value of the policy plus the insurance coverage in the death benefit. Some other life policies pay only the face amount of the policy at death. (12) Term insurance has no value after expiration EXPIRATION. Cessation; end. As, the expiration of, a lease, of a contract, or statute. 2. In general, the expiration of a contract puts an end to all the engagements of the parties, except to those which arise from the non- fulfillment of obligations created of the period of protection. Accordingly, under general principles of accounting, there is no cumulative build-up build·up also build-up n. 1. The act or process of amassing or increasing: a military buildup; a buildup of tension during the strike. 2. of basis. (13) An irregular or nonperiodic Adj. 1. nonperiodic - not recurring at regular intervals aperiodic payment is one that is not fixed as to amount or timing. For example, a lump-sum distribution Lump-Sum Distribution A one time payment for the entire amount due, rather than breaking payments into smaller installments. Some lump-sum distributions receive special tax treatment. of the cash value of life insurance or an annuity is irregular. A regular or periodic payment is one that is fixed as to amount or timing. For example, if the cash value of life insurance or an annuity is received in equal monthly payments over a period of time, the payments are regular. (14) The reader should be aware that there are three substantial negative tax consequences if a cash value insurance policy later fails the tests for life insurance under Sec. 7702 (previously discussed in the section, "Definitions"). First, income on the contract for all prior tax years is treated as received during the current year. Second, any death benefits in excess of cash surrender value are fully taxable instead of being fully excluded. Third, annual income on the contract is treated as ordinary income received by the policyholder Policyholder An individual who owns an insurance policy. under Sec. 7702(g). Income on the contract is defined as changes in net surrender value surrender value See cash surrender value. plus the cost of insurance protection provided under the policy less the premiums paid. There are no such negative consequences for an annuity. (15) Sec. 72(e)(5)(A) and (C). (16) Under the general rule of Sec. 72(e)(2)(a), any irregular distribution received on or after the annuity starting date is fully taxable without regard to basis. Sec. 72(e)(5)(c) excepts life insurance from the general rule. (17) Sec. 72(e)(5)(E). (18) Sec. 72(b)(3). (19) Sec. 1211 (b). (20) Sec. 72(e)(5). (21) Sec. 72(e)(3). (22) Id. (23) Sec. 72(q). (24) Secs. 163(h) and 264(a). (25) Sec. 724(e)(2),131, (4) and (5)(B). |
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