In response to the COVID-19 pandemic, Congress passed the Consolidated Appropriations Act, 2021 (Act), one of the largest spending bills in history. Although the Act focuses primarily on providing relief to those negatively impacted by the pandemic, there was a historic change made to Internal Revenue Code Section 7702. Section 7702 defines "life insurance contract" and sets forth the requirements for such a contract. Section 7702 has remained unchanged since its enactment in 1984, but the Act changed the guaranteed insurance rate for cash value accumulation from 4% to 2% for 2021, and a variable rate will be used thereafter. This change comes in light of historically low interest rates and will certainly have an impact on the life insurance industry.
The higher guaranteed rate of 4% posed a real and practical problem for insurance companies, especially as interest rates have plummeted. The change to Section 7702 has been immensely positive for the insurance industry and will allow life insurance to survive and even thrive in this ultra-low interest rate environment. The Section 7702 changes will result in more efficient cash value growth, which makes life insurance products more attractive for policy owners using them for accumulation and distribution.
The new Section 7702 changes do not apply to policies already in force. Current policies will be limited by the contribution limits stated in the original contract language. However, it seems as though material modifications to a policy, like an insurance benefit increase, could be treated as a new policy. We anticipate that this uncertainty will be clarified soon.
The pandemic has impacted the underwriting process for insurance companies as well. As the seriousness of the pandemic grew, insurance companies temporarily restricted or delayed new coverage for insureds at greater risks of COVID-19 complications. As the COVID-19 vaccines continue to be rolled out, vaccination will likely be looked at favorably during the underwriting process.
Life Insurance as Part of an Estate Plan
The recent changes to the law will make life insurance more attractive to many individuals and families in their end of life planning. Many of the wealthiest U.S. taxpayers are turning to guaranteed life insurance policies with an internal rate of return of over 4% at life expectancy to provide liquidity in their estates (i.e. to have readily available cash to cover taxes and estate administration expenses that might otherwise require the forced sale of illiquid assets at an inopportune time, such as business interests). Besides liquidity for an estate, life insurance offers a death benefit that can be structured as tax-free in both term and permanent policies and tax deferred growth of cash value in permanent policies. Individuals may also decide to utilize an irrevocable life insurance trust (ILIT) to hold their life insurance policies. Policies can either be assigned to the trust or purchased by the trustee with cash contributed by the insured. A well drafted ILIT can allow the proceeds of the life insurance policies to pass free of estate tax on the death of the insured and the insured's spouse, further maximizing the estate planning benefits of life insurance.
With the federal estate and gift tax exemption at an all-time high, different estate planning vehicles have become more popular. Insurance can play a role in structuring certain popular trust structures. In particular, the use of a Spousal Lifetime Access Trust (SLAT) allows a grantor to "lock-in" his or her exemption amount in the event the federal estate and gift tax exemption is later decreased. The current exemption levels are due to sunset at the end of 2025 and revert back to prior rates, adjusted for inflation, but a new tax bill could bring about change more quickly. Upon the grantor making a gift to a SLAT, a portion of the gift can be used to fund life insurance. Using a portion of the gift to fund life insurance helps reduce the taxable investment income held in the SLAT.
Another planning strategy can be implemented through the use of a Grantor Retained Annuity Trust (GRAT). GRATs are a great way to transfer assets from one generation to the next in a gift-tax efficient manner. During a low interest rate environment, GRATs are even more effective. The major risk of a GRAT is the death of the grantor during the GRAT term, which causes the assets in the GRAT to revert back into the grantor's taxable estate. However, the remainder beneficiary of a GRAT could acquire a convertible term life insurance policy that has an insurance benefit equal to the amount expected to be transferred to the remaindermen after the GRAT term ends. The purchase of term life insurance provides a low-cost mortality hedge. If the grantor died during the GRAT term, the remaindermen could still receive the insurance proceeds, which would be free of income and estate taxes.
There are numerous possibilities and options when it comes to life insurance and implementing it as part of your estate plan. The combination of low interest rates and product innovation makes it critical for individuals to review their existing life insurance portfolios. The rate change to Section 7702 only provides more flexibility for life insurance companies to create more unique products.
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