Life insurance enjoys favorable tax treatment as an asset that can be owned throughout its lifespan without incurring income taxes. The policy’s account value accumulates free of recognition of income for tax purposes in the same way as an annuity. In addition, when the policy results in a death benefit, the beneficiary receives it without its inclusion as ordinary income. Furthermore, unlike an annuity, withdrawals from a life insurance policy are first treated as a return of basis before they are considered a receipt of taxable gains. Policyowners can also take loans against the policy’s account value (at a low net interest expense) as a tax-free distribution. Typically, this is done after first withdrawing the policyowner’s entire basis in the contract. As long as the policy remains inforce until death, the policy loan balance is deducted from the death benefit and is not subject to income tax. If the policy is surrendered prior to a death claim, the amount received in excess of the policy’s basis is taxed as ordinary income.
Because life insurance can be utilized in many ways that minimize taxable income, the IRS has prescribed several rules that must be adhered to in order to receive these tax benefits. First, policies must be issued as non-modified endowment contracts (“non-MECs”) with minimum required death benefits depending on the amount of premiums paid into the policy within the first seven years [IRC Sec. 7702a]. Policies classified as MECs are treated similar to annuities with respect to distributions. Additionally, policies must always maintain a minimum amount of death benefit in relation to the policy’s account value until age 95 or 100 (depending upon the chosen Definition of Life Insurance test). Because of the consequences associated with violating these rules, insurance companies have administration systems designed to assure policy compliance.
Registered VUL products share a number of characteristics with PPVULs. Both have similar tax expenses generated for insurance companies, which are typically passed along to policies. In addition, both have similar mortality charges as well as similar types of policy charges (e.g., administration charges, asset-based charges, etc).
However, there are some differences. PPVULs are much more flexible in terms of both policy charges and structure. Since each policy is a private offering to a specific individual (rather than a general offering to the public) the policy can be customized to the client’s needs. This can mean that factors that affect the insurer’s expenses can be reflected in the pricing of the policy. For example, the cost of issuing a policy might be similar for an insurance company despite differences in the size of the policy. Economies of scale might result in the ability to have a policy issued with lower unit charges. In addition, the mortality risk for high net worth clients is historically lower than that of the general public. This lower risk can result in lower mortality charges over time.
Policy assets are held in separate accounts not accessible by the insurer’s creditors and can be reallocated between available investment choices without penalties or tax consequences.
A properly structured PPVUL policy will not be taxed on the growth of its value until it is fully surrendered. Withdrawals (up to cost basis) and properly structured policy loans may be taken on a potentially tax-free basis. In addition, death benefits are not taxed as income to beneficiaries. Policyowners invested in exempt investment funds do not receive K-1 statements.