Internal Revenue Code (IRC) Section 7702 was implemented in 1984, Section 7702A in 1988, and up until recently had remained untouched. Section 7702 defines the requirements that must be met for an insurance contract to qualify as a life insurance contract for federal income tax purposes. Under Section 7022 a life insurance contract must comply with one of two tests:
- Cash Value Accumulation Test (CVAT) requires that the cash surrender value of a contract not exceed the net single premium that would have to be paid at that time to fund future benefits under the contract. If the cash surrender value is higher than the payments the product would not be considered a life insurance policy.
- Guideline Premium and Corridor Test (GPT) limits the premiums that a policyholder can pay into the policy relative to the death benefit. Premiums paid into the policy cannot be more than it would be necessary to fund the insurance benefits.
Section 7702A defines when a life insurance contract becomes a Modified Endowment Contract (MEC) under a 7-pay test. If premiums paid into a policy at any time during the first seven years are more than what was needed to be paid within that seven-year time frame, the policy would become a MEC. When a policy becomes a MEC it is taxed less favorably on lifetime distributions. Any distribution from a MEC, including loans or cash received from the policy, is taxable to the extent of the gain in the policy.
For the past 30+ years, the interest rate for CVAT and the GPT Level Premium was held at 4% and for the GPT Single Premium, it was held at 6%. While the rates had to remain at these levels, market interest rates have decreased, and insurers have had to generate a return on assets that was higher than that market rate. Now in 2021, The Consolidated Appropriations Act has made changes to the interest rates that were set in Section 7702.
The new set rates will be more aligned with current market and guaranteed interest rates: CVAT and the GPT Level Premium are at 2% and the GPT Single Premium is now at 4%. These rates are effective for contracts issued on or after January 1, 2021.
What the changes mean:
Non-MEC premium increases are substantial.
The policy can accumulate cash value more efficiently.
A policyowner can now put in more premium per dollar of death benefit than before without having the policy become a MEC.
Short-pay (or limited pay) products will see a pricing increase.
In the next few months, insurers will evaluate their products and decide how they would like to design and price new products to adjust to the revisions of the Section 7702. With the rates remaining the same for the past 30 years, this will be a process for the insurers to make a change. Executive Benefits Network is in communication with many insurers to understand their timeline and product offerings to give our clients the most up to date information.