The Consolidated Appropriations Act (CAA), 2021 was signed into law by the President on December 27, 2020 which made a significant change to the calculations used inside of life insurance policies. Buried deep in the 5,593-page bill are monumental changes specifically to IRC Section 7702. This is the first change to Section 7702 since it was originally established back in 1984 when Congress thought that wealthy individuals were accumulating too much cash value in life insurance policies. This section of the code determines the premium limits for life insurance policies before they would become a Modified Endowment Contract (MEC) and receive potentially adverse or less favorable tax treatment which includes the cash value accumulations test provision as well as a guideline premium limitation provision. The Cash value accumulation test has been based on a 4% fixed interest rate benchmark and the guideline premium test is based on a 6% fixed interest rate benchmark. The provision inside the CAA that addresses Section 7702 slashes the rate from 4% down to 2% for 2021 and to a variable rate after 2021 to be more in line with current Federal interest rates.
Life insurance companies have been begging Congress for years now to change the interest rate benchmarks as rates have steadily declined since the provision was originally introduced almost 40 years ago now. Now that this has passed, and effective January 1st life insurance companies are on a mission to create and/or redesign their existing cash accumulation life insurance products so clients can contribute substantially more premiums for the same amount of death benefit or achieve a lower death benefit with significantly lower premiums.
What is Private Placement Life Insurance (PPLI)?
Private placement life insurance (PPLI) is a niche solution designed for wealthy individuals in high tax brackets who have a few million dollars available to commit. Permanent life insurance comes with several important tax benefits, which can be major considerations for those in the highest tax brackets. But standard life insurance policies you can get from your neighborhood agent do not contain the hedge funds, funds of funds and other alternative investments that these investors require for their own diversification and investment needs. That is where privately placed life insurance comes in: Wealthy families, family foundations, trusts, corporations and banks work with hedge funds and money management firms to create their own life insurance contracts, designed to reduce their tax burdens.
There are significant tax benefits to utilizing PPLI, the investment growth of the cash value is not subject to taxation if policy loans are taken out – and all of the gains are wiped out in the event of a death – hence the “life insurance” component. The policyholder is able to take a tax-free loan out during his or her lifetime against the policy up to 90% of the policy’s cash value, and most importantly at death, the benefit passes tax-free to your heirs and potentially estate-tax free, creating significant intergenerational family wealth. In plain English, the policyholder’s account value grows tax-free, can be withdrawn tax-free, and is received tax-free by beneficiaries at death.
In the example below using the updated Section 7702 rates we can contribute more than double the premium we could previously $303,600 vs $634,300 and retain a higher cash value percentage 77.14% vs 89.17%. The overall impact to the family at age life expectancy (age 85) is an increase of $3,574,090 in death benefit to the beneficiaries and at age 100 that increases to $30,775,146.
With the possibility of tax law changes this year impacting several estate planning techniques to safeguard and protect assets likely going away life insurance will become an increasing necessity in a client’s overall portfolio.
To read more on the possible estate tax changes please click here.