subject: Life Insurance- How the IRS Defines it for Tax Purposes [print this page] Life Insurance- How the IRS Defines it for Tax Purposes
Understanding life insurance is not at all difficult, but understanding the premise of life insurance policies as the IRS does is a little more complicated. In 1984, as more people began using life insurance policies as an unlikely investment option, the IRS sought to create a comprehensive definition of the coverage so that it would meet tax requirements and so that people weren't getting away with something like tax evasion. Tax laws state that in order to qualify a policy as insurance, it has to meet a cash value test or a cash value corridor and guideline premium test.
The test for cash value accumulation basically states that the cash surrender value of the policy does not exceed the single net premium that has been paid for future benefits. That applies to single premium policies where people face stricter tax regulations for investing in such a policy, meaning that people who pay a $20,000 premium, for example, the cash value could not exceed that amount within the policy, and any funds over that amount are subject to heavy taxation and penalties in many cases.
The premium that you pay should support the minimum amount of insurance and the cash value, which is the target premium according to the IRS. This target is the level of funding that is recommended to maintain a policy, and it will be based on conservative assumptions of return on investment and will be comparable to whole life insurance premiums. If you have a universal life policy, you have to include an amount at risk. The cash value rising to close to the face value of the policy means that death benefits must also increase to provide coverage for what is at risk. The minimal separation between the benefit amount and the cash value is known as the corridor, which states that benefit to cash ratio needs to be below a specific percent, which is based on age.
A 40 year old cannot have a policy with a face value of less than 250% of the cash value and this percentage declines with each year up to age 95. This means that insurance companies have to refuse excessive premium payments to increase death benefits in the event that they are going to exceed this rule. If the rules listed here are met, a policy is a tax-free life policy where death benefits are paid without taxation. If not, tax penalties are imposed.
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