Life insurance policies can be tailored to meet a variety of needs. Some cover more than one person, while others are used to protect a child’s future insurability. Flexible premium options give policy owners the ability to adjust payments and benefits. Certain tax rules also apply when policies are funded too aggressively in the early years, which can affect their tax treatment going forward.
Joint life may be issued as term or whole life. A joint life policy covers two or more lives and pays the death benefit upon the death of the first person covered by the policy.
In contrast to a joint life policy, a survivor policy pays the death benefit upon the death of the last of the two or more lives covered under the policy. This is often referred to as a “last to die” (or second to die) policy.
There are many reasons to purchase life insurance on a child. Typically, juvenile policies are issued to an adult family member and are assigned to the child at the age of majority. A common objective of juvenile insurance is to protect the child’s insurability. A popular variation of the juvenile policy is the jumping juvenile policy. This policy has higher premiums in the early years (until age 21). As a result, cash values accumulate rapidly, creating a source of funds from which to borrow to provide for college expenses. At age 21, the policy face amount “jumps” up to 5 times its original amount. The premium, while high in the early years, remains level and adequate for the new higher face amount.
In response to a demand for market competitive products, the life insurance companies have developed flexible premium products that offer the policy owner the ability to adjust, at will, the level of premium he/she pays on a policy.
Adjustable life policies introduce the flexibility to convert to any form of insurance (such as from term to whole life) without adding, dropping, or exchanging policies. Adjustments can be made prospectively only, affecting the future premiums and death benefit, but in no way amending the past. Adjustments can include increasing or decreasing premiums and the face amount. If the policy owner so chooses, he/she may make a small premium payment or none at all, as long as there are sufficient cash values to pay required company charges.
A universal life policy offers the flexibility of adjustable life and an interest-sensitive feature in that each month the accumulated cash value of the universal life contract will be credited with interest at the current rate. The current rate consists of two parts:
Each year, the insurer projects its current interest rate, which combines the minimum guaranteed rate and any excess interest they anticipate earning above the minimum. For example, if the guaranteed minimum rate is 4% and the insurer anticipates earning 2% in excess of that, the current rate would be 6%. The current rate is guaranteed for that year and will be recalculated the following year.
While premiums are flexible, rather than minimize premium payments, most adjustable and universal life policy owners try to maximize their premiums and build as much cash value as possible. The reason for this is that these policies offer competitive interest rates and the funds grow tax deferred.
At one time, investors used the rapid tax deferred accumulation of cash values in these policies as a place to put money and then borrow out the cash values, income tax free. This created a highly tax-favored investment with tax deferred growth and tax free withdrawals (loans) at will.
In 1988, the IRS caught on and established the “seven pay” test. The Technical and Miscellaneous Revenue Act (TAMRA) established special rules for life insurance policies that fail to meet the seven pay test. An insurance policy will fail to meet the seven pay test if the amount paid in premiums during the first seven contract years exceeds the sum of the seven level annual premiums required to pay up the policy. If too much money is “invested” in a whole life policy in the first seven years, it becomes a modified endowment contract (MEC) and loses its tax advantages.
Distributions, including loans, from an MEC are taxable as income at the time received to the extent that the cash value exceeds the premiums paid. In addition, a 10% IRS penalty is imposed on distributions from an MEC unless the owner is disabled or past age 59½.
Joint life policies cover two or more lives and pay the death benefit upon the death of the first person covered. Survivor life policies pay the benefit upon the death of the last person covered, known as a “last to die” policy. Juvenile insurance includes policies issued to adult family members for the child’s future benefit, typically to safeguard their insurability. A jumping juvenile policy is a variant with higher early premiums, promoting rapid cash value growth to fund future expenses.
Flexible premium policies offer customization, enabling policy owners to adjust premium levels at will. Adjustable life policies permit conversion between insurance forms and adjustments to premiums and face amount. Universal life policies combine adjustable life flexibility with interest-sensitive features, crediting cash values monthly with interest rates, including a minimum guaranteed rate and an excess rate calculated annually.
While adjusting premiums is possible, policyholders of adjustable and universal life policies typically maximize payments to accumulate cash values tax-deferred. The “seven pay” test, established by the IRS in 1988, governs premium payments affecting the tax status of whole life policies. Exceeding the seven pay limits transforms a policy into a modified endowment contract (MEC), causing tax implications on distributions unless certain conditions are met or penalties may apply. Any significant policy changes to pre-1988 policies can jeopardize their tax-advantaged status, leading to MEC classification.
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