GGD-90-31 Tax Policy: Tax Treatment of Life Insurance and Annuity Accrued Interest

GAO

Report to t lw Chai man, Comui t t ee OII

Finance, U.S. Senate, and the

Chairman, Committee on Ways and

Means, House of Representatives

January 1990

TAXPOLICY

Tax Treatment of Life

Insurance and Annuity

Accrued Interest

GAO/GGD-90-3 1

General Government Division

B-237966

January 29,199O

The Honorable Lloyd Bentsen

Chairman, Committee

Finance

United States Senate

The Honorable Dan Rostenkowski

Chairman, Committee on Ways and Means

House of Representatives

This report is in response to Section 5014 of the Technical and Miscellaneous Revenue Act of

1988. Section 5014 calls for

GAO

to report on (1) the effectiveness of the revised tax

treatment of life insurance products in preventing the sale of life insurance primarily for

investment purposes; and (2) the policy justification for, and the practical implications of,

the present treatment of earnings on the cash surrender value of life insurance and annuity

contracts in light of the Tax Reform Act of 1986. There is a recommendation to the Congress

in chapter 4.

As arranged with you, unless you publicly announce the contents of this report earlier, we

plan no further distribution until 2 days from the date of the report.

Major contributors to this report are listed in appendix II. If you have any questions, please

call me on 275-6407.

Jennie S. Stathis

Director, Tax Policy and

Administration Issues

Executive Summ~

Purpose

The interest that is earned on life insurance policies and deferred annu-

ity contracts, commonly referred to as “inside buildup,” is not taxed as

long as it accumulates within the contract. By choosing not to tax the

interest as it is earned, the federal government forgoes an estimated $5

billion in tax revenue each year.

In the Technical and Miscellaneous Revenue Act of 1988, Congress

asked

GAO

to examine the policy justification for, and practical implica-

tions of, this tax treatment. Congress also asked

GAO

to study how effec-

tively the revised definition of life insurance contained in the new law

restricted the sale of investment-oriented life insurance products.

Background

Inside buildup is not a form of income unique to life insurance or annu-

ity products. It is another name for unrealized or accrued income-

income earned but not yet received by an investor. Other examples of

investments with accrued earnings are certificates of deposit, individual

retirement accounts, 401(k) plans, original issue discount bonds, stocks,

bonds, and real estate.

In general, inside buildup earned on life insurance and deferred life

annuities is not taxed as long as it remains inside the policy. Since the

buildup grows faster than it would if it were taxed, buyers pay lower

prices for these products.

Interest that remains inside a life insurance policy accumulates as long

as the policy is in force. The amount accumulated benefits the policy-

holder because it helps pay the increasing cost of insurance coverage as

the policyholder ages and it becomes an increasing part of the policy’s

death benefit. The inside buildup is not subject to income tax if it is

received as death benefits by the policy’s beneficiary. Inside buildup is

taxed if the policyholder surrenders the policy, but not if the policy-

holder merely borrows the inside buildup.

Inside buildup accumulates in life annuities only between the time the

annuity is purchased and the time payments from the annuity begin.

Unlike life insurance, funds borrowed from an annuity are taxed and a

penalty tax is imposed. Once payments from the annuity begin, the pre-

viously untaxed inside buildup is paid out over the term of the annuity

as part of the payment. The inside buildup received with each payment

is then subject to taxation.

P8ge 2

GAO/GGD4031 Turrtlon of Indde Buildup

Executive Summiuy

Results in Brief

After examining the major arguments for the current tax preference,

GAO

found only one to have potential merit-without this preference,

people may not provide their dependents with adequate insurance pro-

tection or themselves with sufficient retirement income. However,

GAO

believes that inside buildup is accrued income that could be taxed.

Accordingly, Congress may want to reconsider whether the social bene-

fits of not taxing the inside buildup are worth the tax revenue forgone.

If Congress decides not to tax inside buildup,

GAO

believes that amounts

borrowed from life insurance inside buildup should be taxed. Since bor-

rowing the inside buildup reduces death benefits by the amount bor-

rowed, such borrowing is not consistent with the goal of the tax

preference, which is to foster insurance protection. In addition, an

unlimited right to borrow the inside buildup allows policyholders access

to tax-free income and is inconsistent with the tax treatment of borrow-

ing from other tax-preferred products, such as annuities. Repayment of

previously taxed amounts borrowed should be tax deductible, because

repayment restores the death benefit.

Congress has narrowed the tax definition of life insurance, but that defi-

nition is likely to remain an issue as long as preferential tax treatment is

granted to life insurance products. The 1988 restrictions appear to have

reduced substantially the sale of a particular type of investment-ori-

ented product-that involving a single premium paid upfront. Whether

these restrictions have affected the sale of other investment-oriented

life insurance products is more difficult to evaluate.

GAO Analysis

The Inside Buildup Debate

Opponents of taxing inside buildup argue that it is not income and

should not be taxed because it does not usually generate cash to the

owner unless the product is surrendered or liquidated. Instances exist,

however, under present law where income is taxed without cash pay-

ment. For example, the annualized return on original issue discount

bonds is taxed as it accrues even though no cash may be received until

some time in the future. (See pp. 38 and 39.)

Alternatively, there are instances under current law where income is not

taxed until cash is realized. For example, accrued capital gains are not

taxed, even though they could be considered income. There are two

Page 3

GAO/CiGDMl Taxation of Inside Buildup

Executive Summmy

basic arguments for taxing capital gains only when the underlying

assets are sold. First, it would be difficult to value many assets that

have accrued capital gains, especially if they have not been sold in

years. Second, asset prices can fluctuate substantially from year to year.

Thus, taxing accrued capital gains could result in the forced sale of an

asset to pay the tax.

GAO

believes that the payment of cash is not a necessary condition for

income to exist and to be taxed.

GAO

also believes that the arguments for

not taxing accrued capital gains do not apply to inside buildup on life

insurance or annuity products. Inside buildup is an amount that can be

readily computed, and the tax on it wiII not likely be large enough to

force even a partial surrender of the policy. Thus, the arguments for not

taxing inside buildup must be based on other factors. (See p. 39.)

GAO

found one argument for not taxing inside buildup to have merit. The

argument is that taxing it may reduce the amount of insurance coverage

purchased and the amount of income available to retirees and benefi-

ciaries. The tax preference on inside buildup is less costly, it is argued,

than direct government provision of protection.

Adequate coverage for low-income people is largely provided through

the Social Security System, which provides both insurance and annuity

protection. The tax preference given life insurance and deferred life

annuities mainly benefits middle- and high-income people. Empirical

studies on the adequacy of life insurance protection are not conclusive.

Even if, under the existing tax treatment, the level of protection is ade-

quate,

GAO

has no way to determine if it would remain so if inside

buildup were taxed. (See pp. 41 to 43.)

Inside buildup has never been treated as taxable income. However, the

tax preference has created incentives to construct products that take

advantage of the preference. Accordingly, Congress may want to period-

ically reconsider the policy decision to forgo taxing inside buildup. The

central issue, as always, is whether the benefit of the increased protec-

tion to the insured’s beneficiaries is worth the tax revenues forgone.

(See pp. 44 to 46.)

Policy Loans Defeat

The purpose of life insurance is to replace income lost as a result of the

Purpose of Life Insurance

death of the insured. Borrowing the accumulated inside buildup of a pol-

icy, however, reduces the value of death benefits and, therefore, defeats

the purpose of having life insurance. (See pp. 43 to 44.)

Page4

GAO/GGDBO41T~tlonofI~ideBuildup

J%xecutive Summmy

In 1982, Congress decided to treat borrowing from annuities as taxable

and imposed an additional penalty to offset the advantage of accruing

interest tax free and only paying tax when funds are withdrawn. In

1988, Congress limited borrowing on certain life insurance policies by

narrowing the tax definition of life insurance. One intent underlying

both of these tax law changes was to reduce investor incentives to use

borrowing as a source of tax-free income. (See p. 43.)

In keeping with that intent as well as to make the tax treatment of bor-

rowing against life insurance more consistent with that of other invest-

ment products, borrowing from life insurance should be considered a

realization of income and should be taxed. To offset the advantage of

accruing tax-free interest income before its withdrawal, a penalty-sim-

ilar to that imposed on borrowing from annuities-should be added to

the tax. Since repayment of borrowed amounts restores the death bene-

fit, any amount that was included in taxable income when borrowed

should be deductible when repaid. (See p. 46.)

The staff of the Joint Committee on Taxation has estimated that a tax

on borrowing the inside buildup from life insurance policies would raise,

on average, over $200 million per year. (See p. 36.)

Recent Changes in Law

Have Affected Product

Cc-l,,

ixl.1es

Because of concern about the growth of single premium life insurance

policies, Congress narrowed the tax definition of life insurance in The

Technical and Miscellaneous Revenue Act of 1988. Single premium poli-

ties, which involve a large initial payment, allow significant and rapid

accumulation of inside buildup. The effect of the tax law change has

been to reduce the number of single premium policies sold. The effect of

this change in the law on other investment-oriented life insurance poli-

cies is more difficult to evaluate. (See pp. 32-33.)

Purchases of deferred annuities fell after borrowing from these prod-

ucts was taxed. Growth has since resumed and, in fact, increased after

the Tax Reform Act of 1986 put limits on competitive tax-preferred

products, such as Individual Retirement Accounts. (See pp. 36-37.)

Recommendation

A-

The type of products offered as well as who buys those products can

change. As a result, Congress may want to reconsider periodically its

policy decision to grant preferential tax treatment to inside buildup,

weighing the social benefits against the revenue forgone.

Page 5 GA0/GGD!30-31 Taxation of Inside Buildup

Executive Summary

If Congress decides not to tax inside buildup, then

GAO

recommends that

Congress eliminate tax-free borrowing of life insurance proceeds. Any

borrowing of these proceeds should be considered a distribution of inter-

est income. To offset the advantages of accruing interest income without

tax, a penalty provision needs to be added. Since repayment of the

amount

borrowed

restores the death benefit, any amount that is taxed

when it is borrowed should be tax deductible if subsequently repaid.

Comments

GAO

obtained oral comments

from industry representatives

on this

report. According to them, the current tax treatment of inside buildup is

justified. They believe that recent changes in the tax laws have elimi-

nated serious abuses. In their view, loans are a legitimate part of the life

insurance product and are generally used to serve important social

goals, such as financing a

home

or paying tuition.

Page 6

GAO/GGDgo31

Taxation of bide Buildup

Page 7 GAO/GGD90-31 Taxation of hide Buildup

Contents

Executive Summary

Chapter 1

Introduction

Objectives, Scope, and Methodology

Chapter 2

What Is Inside

Buildup?

Life Insurance and Inside Buildup

Life Annuities and Inside Buildup

Chapter 3

Favorable Tax

Life Insurance and-Annuity Inside Buildup Are Taxed the

Treatment of Inside

Same Inside but Differently Once Outside of the

Product

Buildup Encourages

Comparison of Tax Treatment of Life Insurance and

Investment-Oriented

Deferred Annuities With Other Investments

Products

Implications of Tax Preferences on Life Insurance and

Annuity Products

Chapter 4

The Inside Buildup

Debate

Inside Buildup Is Income

Tax Preference May Encourage Saving Through Life

Insurance Companies but Has Little Effect on Total

Saving

Tax Preference Increases Long-Term Capital Formation

Financed by the Insurance Sector but Not for the

Entire Economy

Insufficient Provision for Beneficiaries’ Future Needs

Provides Primary Support for Tax Preference

Policy Loans Defeat Purpose of Life Insurance and Should

Be Taxed

Conclusions

Recommendation

Comments

Appendixes

Appendix I: Calculation of Excess Premiums on Whole

Life Insurance

Appendix II: Major Contributors to This Report

Page 8

GAO/GGDWl Taxation of bide Buildup

Tables

Table 2.1: Annual Premiums on $100,000 Life Insurance

Policies

Table 2.2: Excess Premiums, Inside Buildup, Cash Value,

and Actual Insurance Coverage for a $100,000

Annual Premium Whole Life Policy

Table 2.3: Excess Premiums, Inside Buildup, Cash Value,

and Actual Insurance Coverage for a $100,000 Single

Premium Whole Life Policy

Table 2.4: Premiums on a $10,000 Life Annuity Beginning

at Age 60

Table 3.1: Premiums for $100,000 Whole Life Insurance

Policies When Inside Buildup Is Taxed and Not Taxed

Table 3.2: Premiums for Deferred Annuity of $10,000

Annually When Inside Buildup Is Taxed and Not

Taxed

Table 3.3: Taxable Income, After Annuitization, on a

$10,000 Annualized Deferred Annuity Computed

Under IRS Formula and Actuarially

Table 3.4: Taxation of Instruments With Accrued Gains

Table 3.5: Premiums Earned on Single Premium and Other

Ordinary Life Insurance

Table 3.6: Sales of Individual Annuities

Table I. 1: Calculation of Yearly and Cumulative Excess

Premiums on a $100,000 Annual Premium Whole Life

Policy

Figure

Figure 2.1: Cumulative Inside Buildup Earned on a

$10,000 Deferred Life Annuity

Abbreviations

American Council of Life Insurance

Certificates of Deposit

first in, first out

Individual Retirement Accounts

Internal Revenue Service

last in, first out

Life Insurance and Marketing Research Association

Page 9

GAO/GGDWl Taxation of Inside Buildup

Chapter 1

Introduction

Certain life insurance and annuity products have historically been

granted preferential treatment under the Internal Revenue Code. During

the 198Os, many of these same products and the methods of marketing

them changed significantly. Concerned about the potential for misuse of

the preferential tax treatment, Congress has placed limits on these prod-

ucts by narrowing the definition of life insurance and by penalizing bor-

rowing against annuities.

Whole life insurance policies are usually paid for with annual premiums

spread over the life of the insured or over a specified number of years.

In the early years of the policy, the premiums more than cover the cost

of insurance. The excess is invested to provide for later years when the

cost of insurance rises. Deferred life annuities pay benefits after a speci-

fied time has elapsed. They may be paid for with either a single pre-

mium or with a series of premiums that stop before or at the end of the

period of deferral.

Both whole life insurance and deferred annuities offer forms of protec-

tion to the purchaser, but they are also used for savings. The basic tax

advantage common to both is that the interest earned on the savings

element is not taxed as it accumulates. For life insurance, the savings

element plus interest earned is used in later years to supplement pre-

mium payments when mortality costs are higher and to pay a part of the

promised death benefits. If the insured dies, the interest accumulation is

paid to the beneficiary and is not subject to income tax. If the insured

surrenders the policy, the interest accumulation will be subject to tax as

long as the cash value plus the sum of dividends previously paid out to

the policyholder is greater than the sum of premiums paid by the policy-

holder. No tax is levied on borrowing the inside buildup. For annuities,

the savings plus interest earned pay a part of the annuity benefits. No

tax is levied on accumulated interest until the annuity benefits are actu-

ally paid out. However, any amount borrowed or withdrawn during the

period of deferral is taxable. Because the interest is not taxed as it is

earned, both the surrender of life insurance policies and the cashing in

of deferred annuities involve postponement of tax.

The exclusion from taxation of most interest income earned on life

insurance and annuity contracts is estimated to cost the federal

govem-

ment over $5 billion a year, according to the Joint Committee on Taxa-

tion. If just the interest income on new life insurance policies were

taxed, revenue would reach about $900 million a year in 5 years, accord-

ing to the Congressional Budget Office.

Page 10

GAO/GGD9041 Taxation of Inside Buildup

chapter 1

Introduction

In the Tax Equity and Fiscal Responsibility Act of 1982, Congress

decided to treat borrowing from deferred annuities as a taxable distribu-

tion. Except for a limited set of circumstances, an additional penalty tax

was imposed on the amount borrowed to offset the benefits policyhold-

ers gained from tax deferral. Concerned about an increasing number of

investment-oriented life insurance products, Congress, for the first time,

explicitly defined a life insurance policy for tax purposes in the Deficit

Reduction Act of 1984. With a rapid increase in the sale of single pre-

mium life insurance products, Congress further narrowed the tax defini-

tion of life insurance in the Technical and Miscellaneous Revenue Act of

1988. To be considered life insurance for tax purposes, a policy must

involve at least seven annual premiums. A policy with fewer than seven

annual premiums is called a “modified endowment policy” and has very

restrictive borrowing privileges, much like those of annuities.

Objectives, Scope, and

The Technical and Miscellaneous Revenue Act of

1988

directed that we

Methodology

examine the policy justification for the current tax treatment of inside

buildup in life insurance and annuity products, as well as analyze the

practical implications of that treatment. In addition, we were to study

how effectively the law’s revised definition of life insurance prevented

the sale of life insurance products primarily for investment purposes.

To examine the justification for, and policy implications of, the current

tax treatment, we examined accounting, actuarial, economic, and insur-

ance journals and periodicals. In addition, we studied statements and

testimony of industry representatives and economic, legal, and insur-

ance experts. From our literature search, we extracted what we believe

to be the primary arguments for and against the current tax treatment

of inside buildup. Chapter 4 discusses these arguments and evaluates

their strengths and weaknesses.

We examined trends in the industry to determine the policy implications

of the tax treatment of inside buildup and the effects of the new defini-

tion of life insurance. Our primary sources of data used to examine

these trends were the 1988 Life Insurance Fact Rook and the 1989 Life

Insurance Fact Book Update, both of which were published by the

American Council of Life Insurance; and various reports and pamphlets

published by the Life Insurance and Marketing Research Association,

Inc. (LIMRA). To gain a fuller understanding of the products that are

available and their relative importance, as well as to discuss the most

recent trends in the industry, we visited the offices of LIMRA and inter-

viewed LIMRA officials.

Page 11

GAO/GGD90-31 Taxation of Inside Buildup

chapter 1

Introduction

We received informal oral comments from representatives of the life

insurance industry. Since they believe the current tax treatment is

proper, they disagreed with our position. Our work was done between

April and September 1989, primarily in Washington D.C. and in accord-

ance with generally accepted government auditing standards.

Page 12

GAO/GGD!W21 Taxation of Inside Buildup

What Is Inside Buildup?

The interest that accumulated on life insurance policies and deferred

annuities was an estimated $45 billion in 1986. Each year policyholders

and future annuitants accumulate an amount of this magnitude on a tax-

free or tax-deferred basis. In deciding whether inside buildup is to

remain tax-preferred or to be considered a source of tax revenue, it is

necessary to understand what it is and the purpose it serves.

‘Inside buildup” refers to the growth of interest income within life

insurance policies and deferred annuities. Inside buildup is not a unique

form of income: it is simply another name for unrealized income or

gains- income that has been earned but not received by an investor.

Unrealized income or gains occur with many kinds of investments.

These investments include certificates of deposit (CDS); individual retire-

ment arrangements (IRAS); 401(k) plans; original issue discount bonds,

such as zero coupon bonds; stocks and bonds (capital gains); and real

estate. For instance,

CDS

earn interest income as they are maturing, but

investors have the option of not receiving the income until the CD has

matured. Stocks and bonds, even though they pay a periodic income as

dividends or coupon interest, may appreciate in value. This appreciation

or capital gain is earned by investors but is not received until the stock

or bond is sold.

Life Insurance and

Inside Buildup

Life insurance enables individuals to reduce the risk of financial loss to

their families or other parties in the event of the policyholder’s death.

Risks are reduced by pooling the risks (i.e., the probability of death) of

many individuals. If the risks are small, the cost to each individual will

also be small. For example, if 10,000 people wished to provide $10,000

to their families if they died in the next year, and the insurance com-

pany estimated that only 10 of the 10,000 people would die during the

year, the cost of the insurance would be $10 per person ($100,000 bene-

fits paid / 10,000 policyholders

= $10 per policyholder). However, if the

insurance company estimated that 5,000 people would die, the cost

would jump to $5,000 per person1

This example illustrates the fundamental nature of life insurance: as the

probability of death increases the cost of insurance also increases. While

the nature of insurance remains the same, the industry has developed a

multitude of insurance products, such as universal life and variable life

‘This example disregards what are called “loading charges.” These costs are included in life insur-

ance premiums so that insurance companies can cover their casts of doing business.

Page 13

GAO/GGD90-31 Taxation of Inside Buildup

chapter 2

What Ia Inside Buildup?

insurance, to meet the varied needs of people. However, all the policies

offered are essentially variations on the two basic types of insurance:

term (temporary) insurance and whole life (permanent) insurance.

Term Insurance

Term insurance pays the beneficiary of a policy the promised death ben-

efits if the insured dies within a certain period of time (usually 1 year).

A l-year term policy involves almost no savings; it is often termed

“pure” insurance.

The premium for a given amount of term insurance increases with the

age of the insured because the insured’s probability of death increases.

With a greater number of people dying each year as a given group of

people grows older, insurance companies must charge higher and higher

premiums to cover the promised death benefits. Thus, a given amount of

term insurance that costs people hundreds of dollars a year

when

they

are in their 20s may cost them thousands of dollars a year

when

they

are in their 60s. For example, a $100,000 l-year term policy that costs a

person $169 at age 25 would cost $2,421 by age 65. If a person age 25

lived to age 99 and purchased a $100,000 l-year term policy each year,

total premiums paid over

the

years would equal $636,187.”

The increasing cost of term insurance is a major drawback in holding

this type of insurance. As people age, their incomes may not increase as

fast as the insurance premiums. The premiums may take a larger and

larger portion of their income over time. This problem is solved with

whole life (permanent) insurance.

Whole Life Insurance

Under a whole life insurance policy, coverage of $100,000 a year from

age 25 to 99 could be purchased for 75 annual premiums of $676, or a

total of $50,700. Whole life insurance pays the beneficiary of a policy

the promised death benefits (face value of the policy) whenever the

insured dies. It does

this

through a combination of decreasing term

insurance and increasing accumulated savings. The sum of these always

equals the face value of the policy.

‘The premiums, which do not include loading costs, are calculated using the 1980 Commissioners’

Standard Ordinary Mortality Table for males, with an interest rate of 5 percent. This example, and

othen throughout the report, are not intended to represent actual policies sold by the insurance

industry. They are used only to describe the relationship between premiums, cash values, and death

benefits

for various kinds of policies.

;

Page 14

GAO/GGDBOCSl Taxation of Inside Buildup

chapter 2

What LB Inside Buildup?

The premiums for whole life may be spread over the life of the insured.

However, unlike term insurance, whole life premiums do not increase

with the age of the insured. The “excess” premiums are invested by

insurance companies and earn interest income for policyholders. For

whole life premiums to pay the increasing cost of mortality (the increas-

ing costs of term insurance as the insured ages), they must be greater

than the premiums for term insurance in the early years of the policy.

The difference between the whole life premiums and the cost of the

actual term insurance provided in the early years of a policy represents

the savings element of life insurance. The “excess” premiums are

invested by insurance companies and earn interest income for policy-

holders. The accumulation of interest income in an insurance policy is

the inside buildup.

The sum of the accumulated excess premiums and interest income

equals the cash value of a policy. The cash value of a whole life policy is

available to policyholders during their lives through surrender of the

policy or through borrowing. As the cash value of a policy grows, the

amount of actual insurance coverage that needs to be provided to main-

tain the face value or death benefits of a policy decreases. However, the

cash value plus the actual insurance coverage always equals the face

value of a policy.

As the insured ages, the cost of insurance coverage begins to exceed the

annual premiums. At this time, the accumulated excess premiums and

inside buildup (accumulated interest income) are used to supplement the

annual premiums. In effect, interest income earned for policyholders by

the insurance company is used so that policyholders may pay the

increasing cost of their insurance coverage and, as will be shown, is used

to supplement the decreasing level of actual insurance protection pro-

vided by the company.

The savings aspect of whole life insurance may be increased by paying

larger and fewer premiums early in the policy. If premiums are paid

early, inside buildup accumulates in greater amounts. For instance, it

was common to pay premiums for whole life insurance over 20 years

instead of over the life of the insured. At the end of 20 years, the inside

buildup and accumulated excess premiums were sufficient to pay the

costs of insurance coverage for the rest of the insured’s life. The savings

element of whole life is taken to the extreme when it is paid for with a

single premium; such a policy provides the greatest accumulation of

Page 16

GAO/GGIMO31 Taxation of Inside Buildup

b-2

what t lndde Buildup?

interest income. Another type of policy, universal life, allows policy-

holders to vary, within certain limits, the amount of death benefits and

the timing and amount of premiums. This policy allows them to deter-

mine how much of their premiums is saved and how the interest income

is used.

One incentive to purchase whole life rather than term insurance is that,

unlike comparable investments, interest income built up within the pol-

icy is not taxed as it is earned. This incentive will vary depending on

how interest rates paid on the savings aspect of life insurance compare

with the rates offered on other taxable investments.

Inside Buildup Illustrated

Table 2.1 shows the annual premiums for l-year term, annual premium,

and single premium life insurance for a $100,000 policy purchased

beginning at age 25. For about the first 25 years, the premiums on l-

year term insurance are lower than those on annual premium whole life.

The difference between the two policies is approximately equal to the

excess premiums that are saved and invested for the whole life policy-

holder.3 For the single premium policy, virtually the entire premium is

saved and invested. The premium plus inside buildup on a single pre-

mium policy is enough to pay the cost of actual insurance coverage over

the life of the insured.

Table 2.1: Annual Premiums on $100,000

Life Insurance Policies

Type ot Policy

1 -Year

Annual

Single

AIP

term

premium

25 $169

$676

$12,432

35 201

676 .

45 433 676 .

55 997 676 .

65 2,421 676 .

75 6.113 676 .

Note: Premiums were computed ustng the 1980 Commissioners’ Standard Ordinary Mortality Table for

males and an interest rate of 5 percent. The premiums do not Include loading costs.

?he difference ia only approximate because under the l-year term policy the insurance coverage

stays at d 100,000 while under the whole life policy the

lnsursnce coverage, not the face value of

the

policy, decreases as the

policyholder ages and the cash value builds up. The cost of insurance cover-

age under a whole life policy is therefore less than under the l-year term policy.

Page

GAO/GGDBMl

Taxation of Inside Buildup

chapter 2

What h lnaide Buildup?

As the cash value (excess premiums and interest income) builds up

within a whole life policy, the amount of actual insurance coverage pro-

vided decreases. If a person reaches the maximum age in a mortality

table, the actual insurance coverage for the last year is zero. The death

benefits are then totally provided for out of the inside buildup. Tables

2.2 and 2.3, based on the premiums used in table 2.1, show the relation-

ships between the excess premiums, inside buildup, cash value, and

actual insurance coverage for the whole life and single premium poli-

cies.4 For l-year term insurance there are no excess premiums, inside

buildup, or cash value.

Table 2.2: Excess Premiums, inside

Buildup, Cash Value, and Actual

Insurance Covemge for a $loO,OCM

Annual Premium Whole Life Policy

Aae

Cumulative

Actual

excess Inside insurance

Premiums

builduo Cash value covemae Face value

$508 $26 $534

$99,466

$100.000

5.609

2,010 7,619 92,381 100,000

45 9,699 8,207

17,905 82,095 100,000

55 11,326

20,165 31,906 68,509 100,000

65 8.335 39.321 47.656 52344 100,000

(2,169)

66,410 64,241 35,759 100,000

85 (22,936) 100,693 77,757 22,243 100,000

95 (51,258) 140,540 89,283 10,717 100,000

99 E8.557) 158.557 100.000 0 100.000

Table 2.3: Excess Premiums, Inside

Buildup, Cash Value, and Actual

Insurance Coverage for a $1 W,ooO

Single Premium Whole Life Policy

Aae

Cumulative

excess

premiums

Actual

Inside insurance

buildup Cash value coveraae

Face value

$12,285

$614

$12,899 $87,101 $100,000

35 10,832 8,271 19,103 80,897 100,000

45 8,493 19,618 28,111 71,889

100,000

55 3.998 36.010

(4.541)

581704

40.008 59.992 100.000

54.163 45.837

100,000

75 (19,659) 88,346 68,687 31,313 100,000

85 (43,764) 124,287 80,523 19,477

100,000

95 (74,484) 165,099 90,615 9,385 100,000

99 au.2441 183.244 100.000 0 100.000

The cash value (excess premiums plus inside buildup) plus actual insur-

ance coverage equals the face value of the policy, $100,000. The excess

4The calculation of excess premiums is presented in appendix I.

Page 17

GAO/GGD90-21 Taxation of Inside Buildup

chapter

What b Inside Buildup?

premiums in the early years are positive when they are saved and earn

interest income. By ages 65 and 75 in these examples, the excess premi-

ums become negative; at this time, the inside buildup begins to supple-

ment the annual premium to pay the cost of the actual insurance

coverage. For the single premium policy, the inside buildup pays the

entire cost of the actual insurance coverage. The remainder of the inside

buildup supplements the actual insurance coverage so that the value of

the death benefits remains constant. By age 99, the highest age used in

the mortality table, the inside buildup has grown to equal the death ben-

efits; the actual insurance coverage at this age is zero.

As can be seen from tables 2.2 and 2.3, the inside buildup on the single

premium policy for each year is greater than that for the annual pre-

mium policy, because the excess premiums invested in the policy in the

beginning are much greater in the single premium policy.

In summary, inside buildup on life insurance is unrealized income to pol-

icyholders, income that is used to help pay the increasing costs of their

actual insurance and to pay an increasing p&t of their death benefits. It

is income that, when realized, may never be taxed.5

Life Annuities and

Inside Buildup

Life annuities are, in a sense, the opposite of life

insurance.

While life

insurance pays a benefit when the insured dies, life annuities pay bene-

fits (usuaIIy annually or monthly) as long as the insured lives or for a

specified period of time if living. Life annuities are used as a source of

retirement income. For instance, people may invest their IRA savings in

life annuities and begin drawing benefits when they retire.

Life annuities may be either immediate or deferred. An immediate annu-

ity is purchased with a single premium and begins to pay benefits right

away. The premium is invested and earns interest income. The interest

income, along with a part of the premium, is paid out as it is earned, and

thus constitutes the annuity’s benefits. When the insured dies, any pre-

mium remaining helps pay the benefits of other annuitants. These

amounts are called “survivorship benefits.” Because the interest income

under an immediate annuity is paid out as it is earned, no inside buildup

accrues in such a policy.

‘See chap. 3 for a discussion of the tax treatment of inside buildup.

Page 18 GAO/GGB904 Taxation of Inside Buildup

chapter 2

What b Innide Bufldop?

Deferred life annuities pay benefits after a specified time has elapsed or

a certain age is attained. They may be paid for with either a single pre-

mium or with a series of premiums that stop before or at the end of the

period of deferment. Like immediate annuities, deferred annuities earn

interest income; unlike immediate annuities, the interest income earned

builds up within the policy during the period of deferment and is availa-

ble to pay annuity benefits. As with life insurance, the sooner the premi-

ums are paid, the greater the amount of inside buildup.

If the interest rates offered on life annuities are competitive, one reason

for buying a deferred life annuity now rather than an immediate life

annuity later is that the inside buildup accumulated during the period of

deferment is not taxed as it is earned. The same annuity may therefore

be purchased with a smaller after-tax premium, measured in present

value terms. For example, a $10,000 immediate annuity may be pur-

chased for a $116,855 premium at age 60. If the insurance company

guarantees an interest rate of 6 percent, the same annuity may be pur-

chased for a $13,403 premium at age 25. However, if people wanted to

save the money themselves to pay the premium at age 60, they would

have to invest $26,594 at age 25, assuming a 6-percent return in a tax-

able investment. Their cost would be almost 100 percent greater.”

Inside Buildup Illustrated

In the same manner as permanent life insurance, inside buildup is

earned but not realized on deferred life annuities. Once annuity benefits

begin, however, interest income stops building up within the annuity.

When part of the accumulated interest income is included in the annuity

benefits, the inside buildup paid out is realized as income.

The inside buildup on deferred life annuities plus the premiums paid

(plus survivor-ship benefits) must equal the single premium on an imme-

diate life annuity of the same amount. This equality can be seen by con-

sidering the premiums and inside buildup on representative immediate,

deferred, and single premium deferred life annuities.

The premiums on a $10,000 life annuity beginning at age 60 and ending

at the death of the annuitant are presented in table 2.4. The premium at

age 60 is $116,855. The same annuity may be purchased at age 25 for 35

annual premiums of only $886 for a total of $21,020; it may also be

purchased for a single premium of $13,403 at age 25. Since the reserves

6There are taxdeferred alternatives to purchasing a deferred annuity. For instance, people may save

through IRAs and buy an immediate annuity when they retire.

Page 19

GAO/GGD99-31 Taxation of Inside Buildup

chapter 2

What Ls Inside Buildup?

(the amount of funds in a policyholder’s account) on both deferred

annuities must equal $116,885 by age 60 if they are to pay the same

benefits, the differences between the premiums are made up with inside

buildup (plus survivorship benefits).

Table 2.4: Premiums on a $10,000 Life

Annuity Beginning at Age 60

Age

Immediate

Type of annuity

Annual

premium

deferred

$886

886

Single

premium

deferred

$13.403

. 886

886

$116.85;

Note: Premiums were computed using the 1971 Male Annuity Mortaltty Table with an Interest rate of 6

percent The premiums do not include loading costs

Figure 2.1 shows the cumulative inside buildup on the annual premium

and single premium deferred annuities. The amount of inside buildup on

the ‘annual premium deferred annuity is about $78,000 at age 60. This

interest income plus the premiums paid, $31,010 ($886 x 35) almost

equals the cost of the immediate annuity.’

The single premium deferred annuity earns a greater inside buildup. By

age 60, when the annuity begins, the inside buildup totals about

$95,000. This buildup is almost 22 percent more than under the annual

premium deferred annuity. In both cases, the inside buildup accumu-

lates tax-free, to the benefit of the policyholder. Only when the annuity

begins is the inside buildup taxed.8

7The difference is made up from the reserves (premiums, interest income,

and

survivorship benefits)

of those annuitanta who died during the period of deferment. Those reserves are allocated to

the

accounts of the living.

‘See chap. 3 for

discussion of the tax treatment of inside buildup

deferred annuities

Page 20

GAO/GGIMO-31 Taxation of hside

Buildup

chapter 2

What la lnaide Buildup?

Figure 2.1: Cumulative Inside Buildup

Earned on a $10,000 Deferred Life

Annuitv

100

Thousands of Ddlan

35 40 45

56 so

Annual Premium Policy

Single Premium Policy

Page 2 1

GAO/GGD9041 Taxation of Inside

Buildup

Favorable Tax Treament of Inside Buildup

Encourages Investment-Oriented Products

The inside buildup on life insurance and deferred annuities is treated

similarly under current tax law as long as the funds remain in the prod-

uct. However, tax law treats funds

that

are withdrawn or borrowed

from a life insurance policy more favorably than funds withdrawn or

borrowed from an annuity.

Tax treatment of investments does not always resemble that of life

insurance and annuities. The tax treatment of interest accumulating in

whole life insurance and deferred annuities resembles

the

tax treatment

of interest accumulating on other forms of deferred compensation, such

as individual retirement accounts. There are, however, important differ-

ences. Unlike these other deferred compensation products, there are no

legal limits

on how

much can be invested in life insurance and annuity

products. In addition, no tax consequences result from borrowing from a

life insurance policy. The only borrowing limit is the cash value of the

policy. The tax treatment of life insurance products closely parallels the

tax treatment of capital gains income. However, it is

not

clear

that

inside buildup

and

accrued capital gains have as much in

common as

their respective tax treatments would indicate.

The tax preference granted to inside buildup increased the variety of

investment-oriented life insurance products and the amounts invested in

those

products. Some of these products have led to concerns that the tax

preference generates products that are geared more to investment pur-

poses than to life insurance purposes. There are different ways of allevi-

ating those concerns. Changing the definition of life insurance is one of

those ways.

To restrict the ability of investors to put large amounts of money in poli-

cies that were more oriented toward generating tax-preferred invest-

ment returns (inside buildup) and less oriented toward life insurance

protection, Congress defined life insurance for tax purposes in the Defi-

cit Reduction Act of 1984. Because of the rapid increase in the sales of

single premium life insurance policies in the mid-1980s, Congress nar-

rowed the definition further in the Technical and Miscellaneous Revenue

Act of 1988.1 The sales of a specific product, the single premium policy,

appear to have fallen as a result of this 1988 tax law. However, it is

more difficult to evaluate how these changes in definition have affected

the

sale of investment-oriented life insurance policies in general.

‘These policies allowed for a large and rapid accumulation of inside buildup. in addition. they often

provided very liberal loan provisions For a more detailed discussion, see Tax Policy: Taxation of

Single Premium Life Insurance (GAO/GQD-88-SBR), October 16,1987.

Page 22

GAO/GGDWl Taxation of Inside Buildup

clupter 3

Favomble Tax Treatment of Inside wlildap

EncouragesI.nveatme nt43rient.d Pnnhcta

More direct approaches exist to achieve the goals of reducing the invest-

ment-orientation of life insurance and of keeping policyholders from

gaining easy access to tax-preferred funds. If the concern is that inves-

tors have the ability to shelter large amounts of income from tax, a tax

on inside buildup or limits on the amount of life insurance that is

granted tax-preferred status might more effectively deal with that con-

cern. If the concern is the ready access to tax-preferred funds through

borrowing, then limiting or taxing borrowing may be a better approach

than altering the definition of life insurance.

Life Insurance and

Annuity Inside

Buildup Are Taxed the

Same Inside but

Differently Once

Outside of the Product

As funds remain inside a life insurance or deferred annuity product,

they generate interest that is credited to the product’s owner. If these

funds remain in the policy or annuity, the interest accumulation is not

taxed. Once the funds are realized (i.e., taken out of the policy or annu-

ity), the tax treatment accorded annuities differs greatly from that of

life insurance. Inside buildup on a life insurance policy may be realized

by the policyholder or beneficiary through (1) death benefits, (2) policy

loans, (3) surrender of the policy, or (4) policy dividends. For annuities,

inside buildup can be realized through (1) liquidation-when payment

of funds into the annuity stops and payment of funds out of the annuity

begins-, (2) loans against the annuity, (3) cashing in the annuity-if

this is allowed-, or (4) policy dividends. In the following sections, we

will describe how each of these forms of realization are taxed under cur-

rent law.

Unrealized Inside Buildup

The inside buildup and, in some types of policies, the policyholder divi-

Not Taxed for Annuities or

dends generated by funds on deposit in a life insurance policy accumu-

Life Insurance

late without current taxation.2 As a result, the inside buildup grows

faster than it would if it were subject to current taxation. The faster the

buildup of interest inside a policy, the lower the premiums insurance

companies will charge for the same coverage. Table 3.1 shows the dif-

ference in premiums on a $100,000 whole life policy under the current

tax treatment-that is, with no tax on inside buildup and with a hypo-

thetical tax of 28 percent on the interest accumulation. Lower premiums

obviously benefit both insurance companies and their policyholders.

‘In certain

situations,

a current tax is generated by the accumulation of policyholder dividends 111 a

policy. See the section on policyholder dividends.

Page 23

GAO/GGEMO41 Taxation of Inside Buildup

Chapter 3

Favorable Tax Treatment of Inside Buildup

Encourages Investment4Mented Products

Table 3.1: Premiums for $100,000 Whole

Life Insurance Policies When Inside

Premiums

Buildup Is Taxed and Not Taxed

Inside buildup not If buildup were

Type of policy

taxed

Annual premium

$676/year

$909/year

Single premium

$12,432

$20 742

Note Premiums based on a poky purchased by a 25.year-old male usmg 1980 Commlssloners Sland

ard Ordmary Mortality Table for males with an Interest rate of 5 percent and a marginal tax rare of 28

percent Premiums do not Include loadmg costs

From the insurance companies’ standpoint, lower premiums mean they

can sell more policies or more insurance per policy. Lower premiums are

possible because the inside buildup grows at a faster rate when not

taxed and can eventually pay a greater portion of the promised death

benefits. From the policyholders’ standpoint, the amount paid for a

given amount of insurance is lower and the amount invested in the pol-

icy (i.e., the unused premiums) earns interest income at a higher rate

than if it were taxed. The cash value of the policy (unused premiums

plus accumulated interest income) is available to policyholders through

borrowing or upon surrender of the policy in whole or in part. i

Inside buildup on deferred annuities is given the same tax treatment

accorded unrealized interest income earned on life insurance. -4s premi-

ums’ are paid into a deferred annuity but before any amount is actually

received by the annuitant, the interest income earned accumulates with-

out any current tax. The owner’s wealth increases with the interest

accumulation and at a faster rate than if the interest accumulation were

subject to current taxation. Table 3.2 shows the difference in premiums

on a $10,000 deferred annuity with no tax and with a hypothetical tax

of 28 percent on the inside buildup. From the standpoint of the annuity

owner, fewer resources or out-of-pocket costs are needed to provide

income for retirement, for example, or for

any

other purpose.

Table 3.2: Premiums for

Deferred Annuity

of $10,000 Annually When Inside Buildup

Premiums

lo Taxed and Not Taxed

Inside buildup not

If buildup were

Type of policy

taxed

Annual premtum

$886/year

$1,48O/year

Single premium

$13,403

$27.064

Note: Premiums based on a deferred annuity purchased by a 25.year-old male to begin at age 60 using

the 1971 Male Ann&y Mortality Table and an Interest rate of 6 percent Premiums do not include loading

costs.

3Surrendering a life insurance policy means exchanging the policy for all or part of its

cash value.

Page 24

GAO/GGD90-31 Taxation of

Inside

Buildup

chapter 3

Fmorable Tu ktanent

Inside

Bdldup

FiwmagaIuvatmenturIeIlted-

Inside Buildup Not Taxed

The basic purpose of life insurance is to provide protection against

When Realized on Death of

income loss to beneficiaries who are often dependents of the insured.

Insured but Taxed When

The death of the insured terminates the whole life insurance policy. The

Realized as Annuity

accumulated interest

income

or inside buildup in a life insurance policy

Benefits

is not taxed when paid to the beneficiary on the death of the insured.

Death benefits have been exempt from federal income tax on welfare

and humanitarian grounds because they are usually paid to a family

that has suffered the loss of the primary earner.4

Liquidation of a deferred annuity terminates the deferral period. Pay-

ment of funds into the annuity has ceased and payment of funds out of

the annuity begins with liquidation. Unlike the accumulated inside

buildup included in life insurance death benefits, the interest accumu-

lated in annuities is taxed when it is paid out as annuity benefits.

Conse-

quently, the inside buildup on deferred life annuities is only tax-

deferred, not tax-free as in the case of death benefits from life

insurance.

The tax law contains a formula that separates the part of an annuity

payment that is interest, and therefore taxable, from the part that is a

return of principal and not taxable. The IRS formula is easier to use than

actuarial tables, but the result obtained from the formula is only an

approximation. It slightly understates taxable income in the early years

and overstates taxable income in the later years. As a result, in the early

years, there is some additional deferral of tax

annuities. Table 3.3

compares taxable income computed under the IRS formula with taxable

income computed using an actuarial table on an annuity that pays

$10,000 a year. For the first 24 years, taxable income is understated by

about $600 a year and then overstated by about $500 a year thereafter.

Table 3.3: Taxable Income, After

Annuitiration, on a $10,000 Annualized

Deferred Annuity Computed Under IRS

Formula and Actuarially

IRS formula

Actuarial formula

First 24 yean Subsequent years

$8,718

$10,000

9,254 9,514

Note: Computations based on a $10,000 annualized deferred annuity beginning at age 60 and pur-

chased at age 25 with 35 annual premiums. The 1971 Male Annuity Mortality Table was used with an

interest rate of 6 percent.

4These death benefita may not totally escape taxation since they are

included in the tax base of

the

federal estate tax and may be subject to state

income or estate taxes. The

current tax credit for the

federal estate tax, however, is equivalent to about a $600,000 exemption so that the applicability of

thetaxislhnited.

Page 26

GAO/GGIHO-31 Taxation oP Inside Buildup

Chapter 3

Favorable Tax Treatment of Inaide Buildup

Jhcourages Investment4h4ented Pmdnrts

Surrendering a Life

The cash value received by a policyholder upon the surrender of a life

Insurance Policy or Taking

insurance policy is subject to income tax to the extent that cash value

a Distribution From an

plus any policy dividends previously received is greater than the sum of

Annuity Is Taxable but the

premiums paid. Thus, the taxation of a full or partial surrender of a life

Treatment Is Different

insurance policy assumes that the principal is recovered first and the

interest is recovered afterwards (often termed FIFO for “first-in-first-

out”). That is, any receipt of cash value is deemed to be first a return of

premiums paid and only then a return of interest income earned. As a

result, partial surrenders need not lead to any payment of tax until the

total amount received is greater than the amount paid.

Not only is the interest income taxed after the principal has been recov-

ered, but the amount that is considered principal for tax purposes is

overstated. The calculation of taxable income uses total premiums paid

as a measure of principal. However, part of the premium in each year is

used to purchase insurance coverage, and the remainder accumulates as

part of the policy’s cash value. As a result, the current method of deter-

mining taxable income, which ignores the cost of insurance, overstates

the amount of principal on which the inside buildup was earned. Since

the principal amount is overstated, the amount of inside buildup taxed

is less than the actual amount earned. A more correct basis for calculat-

ing the taxable interest accumulation would therefore be the sum of pre-

miums paid less the cost of insurance coverage, since it is only excess

premiums that are invested at a return and therefore properly consid-

ered principal.

On the other hand, distributions from an annuity that are over and

above the regular annuity payments are taxed as if they were interest

income first, at least until all of the interest accumulation has been

received. Distributions from annuities are thus said to be taxed on a LIFO,

or last-in-first-out basis. That is, any receipt of funds is deemed to be

first a return of interest income earned-which is taxable-and only

then a return of premiums paid-which is not taxable. In addition, if the

annuitant has not yet reached the age of 59-l/2 or fulfilled certain other

conditions, an additional penalty tax of 10 percent is assessed on the

distribution.

Page 20

GAO/GGD-30-31 Taxation of Inside Buildup

aupter 3

Favorable Tu Treatment of Inside Buildup

Enamqp3 Inve8tmentollenti Producb

Borrowing Against Inside

Buildup Is Tax-Free for

Life Insurance but Taxable

With a Penalty for

Annuities

If a policyholder borrows the inside buildup from his or her life insur-

ance policy, the amount borrowed is considered a transfer of capital, not

a realization of income, and, therefore, is not subject to taxation. This

reasoning is in accord with tax policy on other types of loans, such as

consumer loans or home mortgages. These loans are merely transfers of

capital or savings from one person to another through a financial inter-

mediary. The ability to borrow against a life insurance policy means

that the interest income that is supposed to be building up to fund death

benefits can instead be a source of untaxed current income. If the loans

are not repaid, the inside buildup will never be taxed; death benefits will

simply be reduced by the amount of the loan. Thus, policyholders have

the use of tax-free income for purposes other than insurance at the

expense of reduced death benefits for their beneficiaries.5

The 1982 Tax Equity and Fiscal Responsibility Act treats a loan from an

annuity as a distribution of annuity proceeds for tax purposes. The

amount borrowed is considered a distribution of interest income first

and is subject to tax. The purpose of this treatment is to discourage the

use of annuities for short-term investment and tax deferral purposes,

while maintaining the tax benefits for long-term investment and retire-

ment uses. Taxing amounts borrowed reduces the incentive to realize

income on a current basis from what is meant to be deferred compensa-

tion or savings for retirement. If the annuitant has not yet reached the

age of 59-l/2 or fulfilled certain other conditions, a penalty tax of 10

percent is also assessed on the amount distributed. Due to the time value

of money, it always pays to postpone paying a tax rather than to pay it

currently, unless there is some expectation of a significant increase in

tax rates in the future. As a result, a penalty is imposed to offset the

benefits of deferring the tax on interest income.

Taxation of Policyholder

Dividends Paid on Life

Insurance Differs From

That of Dividends Paid on

Annuities

Roth life insurance and annuities can pay dividends to policyholders to

the extent that investment performance is better than a stated or guar-

anteed rate of return or to the extent that mortality experience turns

out to be better than expected. Part of the investment income on life

insurance policies and annuities can be guaranteed, much like a bond or

some savings accounts, while part of the investment income can depend

on performance and is paid at the discretion of the company, as in cer-

tain money market or equity instruments. Investment income paid at the

5Similarly, homeowners may borrow againat the untaxed equity appreciation in their homes and not

pay an income tax on the funds received. However, the interest paid

a home equity loan is tax-

deductible, while the interest paid on a life insurance policy loan is not tax-deductible.

Page 27

GAO/GGD!bO41 Taxation of Inside Buildup

chapter 3

Pavorable Tu

TreumentofxnddeBl8ibiup

EIKmuaga hlv atment~tedRodaetr

discretion of the company is considered a dividend. If such dividends

are reinvested and left to accumulate inside a whole life insurance pol-

icy, the interest earned on them is taxable. In addition, the dividends

themselves are taxable to the extent that the sum of dividends accumu-

lated over the life of the policy is greater than the sum of premiums paid

by the policyholder.

Policy dividends paid on annuities, however, are usually taxable. If

earned after the annuity starting date, the dividends are included in the

policyholder’s gross taxable income. If earned before the annuity start-

ing date, they are taxed unless retained by the insurer as a premium or

other consideration paid for the anr~.Gty.~

Comparison of Tax

Treatment of Life

Insurance and

Deferred Annuities

With Other

Investments

There are both similarities and differences between the tax treatment of

life insurance and deferred annuities and the tax treatment of certain

alternative investment vehicles.

In one comparison, the tax treatment of 401(k) and deductible IRA con-

tributions is, in effect, the same as the tax treatment of life insurance

death benefits.’ F’unds deposited in 401(k) and deductible contributions

made to IRA plans are tax-deductible. These funds and any accumulated

interest are taxable without penalty when withdrawn from the account

after age 69-l/2. F’unds used to purchase life insurance are not tax-

deductible, but death benefits-including the accumulated interest

income or inside buildup-are not taxed. These two approaches are

equivalent in present value terms if tax rates are the same when funds

are received as when funds are deposited.8

Another comparison showing similar tax treatment is that between non-

deductible contributions to IRAS and life insurance policies that are sur-

rendered. In both cases, the interest income or inside buildup is not

taxed as it is earned, but it is taxed when realized-when funds are

6Ccmaideradons are the amounta paid lnto annuitlex They are the equivalent of premiums on life

insurance pollcles.

‘Deductible IRA contributions are those taken by individuals (single) without a qualified employer-

sponsored pension fund or, up to a limit of $2,000, by those with incomes below $25,000. Nondeduct-

ible IRA contributions are those taken by everyone else. while the

amount conhibuted to such an IRA

is not deductible, the interest income is not subject to tax until the IRA ls cashed ln at retirement.

*Ekcause the amount paid into a 401(k) or deductible IRA la not taxed, the principal invested is larger

by the tax not paid. If this untaxed amount accumulates with interest until withdrawn, the tax on the

amount withdrawn will have the same present value as would a tax on the original amount.

Page 23

GAO/GGD-@O-31 Taxation

Lnside Buildup

Ch8pter 3

Favorable Tu Treatment of Inside Builbp

Encores lnveetment-orlellted Froducta

withdrawn from an IRA at retirement or when the life insurance policy

is surrendered.

Another useful comparison is the similarity in tax treatment of capital

gains, which represent an increase in wealth, and the tax treatment of

accrued interest. Capital gains are not subject to income tax as they

accumulate (or accrue) but are taxable when the underlying asset is sold

and the capital gain is “realized.” This treatment closely parallels the

surrender of life insurance policies because the interest accumulation is

not taxed as it accrues but becomes taxable upon surrender to the extent

that the surrender value exceeds the sum of all premiums paid into the

policy.

The treatment of capital gains at death also resembles the treatment of

life insurance death benefits. Neither is included in the income of the

deceased, and the basis for determining capital gains is adjusted for the

beneficiary, effectively removing any tax liability for capital gains that

occurred from the time of purchase through the time of death. Death

benefits paid from a life insurance policy are also not taxable as income

to the beneficiary.

In contrast, some investments are taxed differently. Interest that

accumulates on certificates of deposit is taxable on a current basis even

though the interest may not be realized by the investor until the certifi-

cate matures. Original issue discount bonds are those with low or zero

coupon or explicit interest rates. These bonds, however, have a differ-

ence between the issue price and the value of the bond at maturity. A

set of rules specified in the tax code imputes annual interest amounts on

these bonds, rather than ahowing taxes to be deferred until cash is

received when the bond matures or is sold. In both these cases, interest

is taxed even though no cash is received. The way that income accrues

on original issue discount bonds most closely parallels the way that

inside buildup accrues in life insurance and annuity products.

Table 3.4 summarizes the tax treatment of these alternative forms of

savings, showing the similarities and differences in tax treatment.

Page 29

GAO/GGIMXil Taxation of Inside Buildup

Favorable Tu htment of h&de

Bdldnp

ElMmmgmlnvutment-orlente!dFrod~

Table 3.4: Taxation of Instruments Wfth

Accrued Gains

Invertment

Contribution is

taxed

$cx\yd gain is Realization of gain

is taxed

Life insurance

Deferred annuities

Nondeductible IRA

contributions

yes

yes/noa

yes

Deductible IRA

contributions

401 (k) plans

no, but amount

limited

no, but amount

limited

yes, principal and

interest

yes, principal and

interest

Certificates of

deposit

Original issue

discount bonds

yes

Capital gains

yes

no yes/nob

%ealized accrued garn

not taxed when received as death benefits; it is taxed when received on

surrender of the policy.

bAccrueci capital gains are not taxed under the income

tax

when the owner dies; on the

date

of the

owner’s death. the asset’s value becomes the benefbary’s new basis for subsequent taxation.

The two aspects in which the tax treatment of deferred compensation

instruments differs most substantially are in “premature” distributions

and borrowing. Premature distribution is the withdrawal of funds from

a retirement instrument before the holder is 59-l/2 years of age, or from

a life insurance policy before the death of the policyholder. Borrowing

from these instruments involves withdrawing funds without forfeiting

benefits if the funds are repaid.

Distributions from IRAS and 401(k) plans before age 59-l/2 involve a tax,

including a lo-percent penalty, on the full amount withdrawn except in

very special circumstances, such as the disability of the owner. If the

owner of a deferred annuity takes a distribution during the deferral

period, the amount is taxed with a lo-percent penalty as well. Early

withdrawals from a life insurance policy are usually made by surrender-

ing part or all of the policy. As discussed earlier, early withdrawals can

be taxed.

Borrowing from

IFUS

is not allowed. Borrowing from 401(k) plans is lim-

ited to one-half of the employee’s accrued benefit in the retirement plan

Page 30

GAO/GGIWS31 Taxation of Inside Buildup

Chapter

Favonble Tu Trutment of Inaide holdup

Emmmgea hwstment0riented Produti

up to a limit of $50,000.g Borrowing from annuities is treated as a distri-

bution from the annuity and is taxed with a penalty. No tax conse-

quences result from borrowing from a life insurance policy, and the only

limits are the cash value of the policy.

Implications of Tax

Preferences on Life

Insurance and

Annuity Products

Different tax treatment of similar investments creates the incentive to

take advantage of those differences. One of the issues in the recent dis-

cussions of leveraged buyouts is the extent to which tax considerations

might influence those buyouts. Since interest paid on debt is deductible

from corporate income and dividends paid to equity holders are not,

incentives may exist to refinance some of a company’s equity with debt.

Incentives can be set up to use financial instruments having many of the

characteristics of equity, but which are treated as debt instruments for

tax purposes.

These incentives have also been an ongoing problem in the area of capi-

tal gains taxation. Due to the favored tax treatment, it always paid to

get income declared as a capital gain rather than as regular income.

Even after the Tax Reform Act of 1986, which rescinded the favored

tax treatment of realized capital gains, the favored tax treatment of

accrued capital gains remains.

The tax preference granted to many forms of pensions and deferred

compensation sets up incentives to take income in that form and to dis-

guise current compensation as deferred compensation. These incentives

require very complicated rules to ensure that what is supposed to be

deferred compensation actually is used for that purpose. Complicated

rules have been established in the tax code, for example, on distribu-

tions from funds and trusts set up to finance deferred compensation or

on loans that use deferred compensation as collateral.

Similar problems arise.with life insurance and, to a lesser extent, with

annuity products. Because of the tax-favored nature of life insurance,

there are incentives to develop a product that looks like life insurance or

can be defined as life insurance for tax purposes. Yet this practice

allows people to shelter income from taxation and may, in fact, allow

use of that sheltered income on a current basis. To deal with this prob-

lem, Congress set up two tests to define life insurance. These tests were

established first, on a provisional basis, in the Tax Equity and Fiscal

‘These loans must be repaid within 5 years, unk~ they are wed to finance the borrowing employee’s

principal residence.

Page 31 GAO/GGIMO431 Taxation of Inside

Buildup

clmpter 3

Fwomble Tax Treatment of hide

Buildnp

Enamragemlnvatmen

t4Mentd pfmdncu

Responsibility Act of 1982 and then, on a more permanent basis, in the

Deficit Reduction Act of 1984.

Under the law, a contract is considered life insurance if it satisfies either

of two alternative tests. Under the cash value accumulation test, a life

insurance contract’s cash value cannot exceed the net single premium

needed to pay all future benefits. Under the guideline premium limita-

tion and cash value corridor test, the premiums cannot exceed certain

guideline levels, and the death benefit cannot be less than a set propor-

tion of the policy’s cash value based on the age of the insured.

These tests may or may not have had the desired effect on life insurance

products that involve more than one large upfront premium, but they

did not appear to effectively limit the use of single premium life insur-

ance products for investment p~rposes.~~ As a result, Congress further

narrowed the definition of life insurance in the Technical and Miscella-

neous Revenue Act of 1988. The act created a new category of products

called “modified endowment contracts”-any policy funded at a more

rapid rate than seven annual premiums. The act required that loans or

other amounts received from these contracts would be taxable to the

extent of the interest that had built up inside the policies. Thus, single

premium policies would be classified as modified endowment contracts,

and loans from them would be taxable.

This restriction appears, at least for the present, to have cut into the

sales of single premium life insurance. Table 3.5 presents the premiums

earned on single premium and other ordinary life insurance from 1984

through 1988. As a percentage of disposable income, premiums on single

premium insurance rose substantially from 1984 to 1987 but fell by over

50 percent in 1988 compared with 1987.

“For a more detailed discusion of the use of single

premium policies to get

around the defuritional

/GGD88-9BR, Oct. 16, 1987,)

ce Should Be Restricted (GAO/

Pyle 33

GAO/GGDWb31 Taxation of Inside Buildup

Favorable Tax Tmatment of Inaide Buildup

Eneoumgealnvastmen toriented Pmduetd

Table

3.5: Premiums Earned on Single

Premium and Other Ordinary Life

Dollars in millions

insurance

Single premium insurance

Other ordinary insurance

Year

Premiums

Percent of Percent of

disposable disposable

income

Premiums

income

1984 $1,032 0.04% $37,593

1 41°-

1985 2,470 0.09 43,626 1.54

1986 5,013 0.17 46,605 154

1987 9.436 0.29 52.698 164

1988

4,800

0.14

53,217

153

Preliminary data from the Life Insurance and Marketing Research Asso-

ciation (LIMRA) that are based on a sample of companies

suggest

that

single premium policy premiums have fallen in the first three-quarters

of 1989 to less than 30 percent of their value for a similar period in

1988. Recently, however, several new products

have

appeared

that com-

ply with the 1988 act but

may

not be in the spirit of

that act.

It is more difficult to analyze whether other investment-oriented life

insurance products are growing and at what rate. Data exist on

the

sales

of variable life insurance, universal life insurance, and universal varia-

ble life insurance.ll Other than the legal definition, no criteria exist for

distinguishing

which of these types of policies

may

be “too investment-

oriented*’ from those that are not. As a result, we cannot precisely eval-

uate the implications of the preferred tax treatment

any investment-

oriented policies that satisfy current law.

New Products and New

Uses of Traditional

Products

The life insurance industry has become a major competitor in the finan-

cial services industry. As a result, new products and new uses of stand-

ard products are constantly appearing. One example of a new product

would be what is called a “combination plan.” This includes an immedi-

ate annuity with a life insurance policy involving 10 annual premiums.

The annuity pays the 10 premiums, but the policy qualifies as a life

insurance product even under the new restrictions and, as a result,

allows borrowing.

‘lVariablelifeinammce iaaformofinaumwe

that allows the policyholder to invest his or her cash

value in a mutual fund, with the cash value retkcting the earning experience of that fund. Universal

life insurance allows the policyholder to change the

death benefit and the

premium payments. These

policies also explicitly

distk@sh

mortality charges and interest rates that affect the policyholder’s

account. Universal variable

offers

the policyholder

a choice of

funds for investing the cash value, as

well as a flexible payment schedule.

Page 33

GAO/GGD9Ml Taxation of Inside Buildup

Favorable Tax Treatment of hide Buildup

~lnvatment.orientedRodncta

Another new product that especially interested Congress is a policy

that

insures two lives, only pays after the second death, and involves seven

annual premiums (the minimum required under the 1988 law). This

product also features a substantial reduction in

the

death benefit in the

eighth year. The high initial death benefit allows

the

policy to qualify as

life insurance, but the reduction in death benefits after the seventh y_ear

frees up more funds for investment purposes.

Both of these products appear to be attempts to comply with the 1988

act while keeping

the

main features of single premium policies that the

law intended to curb. Congress dealt with the second product, the 7-year

joint policy, in the recently passed Omnibus Budget Reconciliation Act of

1989. As a result of this change, any reduction in the death benefit

below what ruled over the first 7 years of

the policy

requires a recalcu-

lation to see if the policy still qualifies as life insurance under the

definition.

Examples of new uses of traditional products include “living benefits”

policies and corporate-owned life insurance. Policies that involve living

benefits pay out some designated part of

the

death benefit while

the

insured is still alive, if certain specified conditions are

met.

These condi-

tions can include the onset of some specific illness, the certification of a

terminal illness, or the entrance into a qualified nursing home. While

there is little difference between borrowing against a policy and taking a

living benefit, the conditions on the latter are much stricter and

the

amounts limited although funds are available sooner.

Many companies insure themselves against the loss of key individuals

(individuals

whose

death would be costly to the company). Recently, a

new type of corporate-owned life insurance has appeared that involves

smaller amounts of insurance but for larger numbers of employees. The

available data on this phenomenon are quite limited. Currently, only a

few companies sell these policies, so the sample size is quite small. As a

result, the amounts fluctuate from year to year and conclusions are dif-

ficult to draw. For example, LIMRA reports that for a sample of compa-

rues, the number of corporate-owned policies rose by about 70 percent,

while the average face value of these policies actually fell from about

$129,000 to about $57,000 per policy

between

1987 and 1988. Compar-

ing the first three quarters of 1989 with a similar period in 1988 but for

slightly

different samples shows a 33percent increase in the number of

policies, while the average face value rose from $65,000 to $249,000 per

policy. These policies do not appear to be purchased for

the

employee or

Page 34 GAO/GGKMMXU Taxation of Inside Buildup

Favorable Tax ‘lkestment of Inside hildnp

Etwomgalnveatment~nted-

the dependents of the employee. The company is generally the benefici-

ary named in the policies; in many states, the employees may not even

know that they are insured.

While key person life insurance policies were used in the past, policies

that involve large numbers of employees do not appear to insure against

the loss of particular persons and the economic loss that would be suf-

fered by the company with their deaths. Rather, the companies appear

to be using the tax-deferred inside buildup and the death benefits to

shelter income needed to finance currently unfunded liabilities, such as

those incurred for future health benefits. This practice may be, in part,

a response to a new set of accounting rules promulgated by the Financial

Accounting Standards Board that would require the costs of future lia-

bilities on retiree health benefits to be accounted for on a current basis.

In addition, the borrowing privileges allow use of the funds to finance

current activities. At present, this type of policy appears to be limited to

a few companies. Because health benefits for retirees are projected to

grow very rapidly, this method of funding could become more

widespread.

Implications of Not Taxing

Life Insurance Borrowing

Single premium life insurance policies were a source of concern not only

because of the rapid buildup of interest inside the policy, but because

they offered the potential for significant future borrowing against that

inside buildup. As was discussed earlier, the policy loan is the one aspect

of a life insurance policy whose tax treatment differs substantially from

that of other deferred compensation items.

If the interest rate charged on a policy loan is low compared to market

interest rates, a simple and profitable opportunity exists for the policy-

holder to borrow the inside buildup at the lower policy rate and reinvest

it in something that earns a higher rate. No tax is assessed on such a

transaction. Something like this appears to have occurred in the United

States between 1965 and 1982. In 1965, policy loans outstanding were

about $7.7 billion (less than 5 percent of life insurance industry assets).

In 1982, policy loans were $53 billion (about 9 percent of industry

asSetS>.

In recent years, the difference between the interest rate charged on pol-

icy loans and rates that can be earned on investments has narrowed. As

a result, outstanding policy loans have not increased, and as a propor-

tion of assets, they have decreased to about 5 percent. However, each

year an amount in the range of $9 to $12 billion is borrowed from life

Page 35

GAO/GGIMO-31 Taxation of hside Buildup

insurance policies. In addition, the stock of outstanding policy loans still

represents about 20 percent of the industry’s ordinary life insurance

reserves.

One aspect of certain single premium policies that drew attention was

that they offered zero net-cost policy loans. The companies offered these

loans by crediting to the policy an interest rate that was the same as

that charged on the loan. This practice allowed policyholders the option

of borrowing the interest accumulation without tax and without any

requirement to pay back the loan. The concern generated by investment-

oriented life insurance products in general, and single premium policies

in particular, led to the introduction of the Stark-Grad&m bill in 1987.

The bill would have taxed loans from life insurance policies as distribu-

tions in a manner that parallels the treatment of deferred annuities. The

staff of the Joint Committee on Taxation estimated that this would have

raised about $700 milhon over a 3-year period.

Rather than enact the Stark-Gradison biIl, which would have affected a

broad range of policies, Congress chose to restrict its attention to single

premium policies. Under the Technical and Miscellaneous Revenue Act,

Congressputlimitsontheabihtyto

bo~owagainstsinglepremiumpoli-

ties

by defining a class of product that was not considered life insurance

for tax purposes. This definition excluded any policies that involved

fewer than seven annual level premiums. As noted earlier, new policies

are being developed that may get around these rules. This circumven-

tion is one of the we- of the definitional approach. If sales of

these new products become substantial or if the amount of borrowing

from existing policies grows significantly, Congress may find it neces-

sary to tackle the issue of borrowing more directly.

Past Changes in Tax Law

As a rest& of changes enacted in the Tax Equity and Fiscal Responsibil-

Hurt but Recent Changes

ity Act of 1982, borrowing against deferred annuities is presently con-

May Have Helped Sales of

sidered a taxable distribution. In addition, if that borrowing comes

Deferred Annuities

before the policyholder is age 59-l/2 or does not meet certain other con-

ditions, a penalty tax of 10 percent is added. As we can see from table

3.6, this change may have led to a small drop in annuity sales between

1982 and 1983. However, since then, these sales have resumed their

upward trend. Over the g-year period covered by table 3.6, the sale of

individual annuities increased substantially faster than after-tax

income, whi.Ie the premiums

individual life insurance rose at about

the same rate. There are many possible reasons for this increase in

annuity sales. Since the Tax Reform Act of 1986 narrowed the limits on

Page 36

GAO/GGD3O41Turtbn

ofIn.eideBuildup

Favorable Tu Treata~~~t of Ix&de Buildup

Eneonragulnve8tmul

t4hlent.d Pmlucta

IRAS and other tax-preferred deferred compensation items, annuities

have

become more attractive. An additional source of funds moving into

deferred annuities may be funds that would have gone into single pre-

mium life insurance before the limitations were enacted.

Table 3.6: Salea of lndlvidual AnnultIer

Dollars in millions

Annulty

conalderatlonr as

lndlvldual insurance

Individual annuity

Year

conrlderatlons

portent of a$---;

premiums as percent

of after-tax income

1980

$6.296

0.33%

1 .54%

1981 10,290 0.48 1.62

1982

15,196

0.67

1.70

1983 14,003 0.58

156

1984 15.706 0.59 1.45

1985

20,891

0.74

1.62

1986 26,117 0.86

1.71

1987

33,764

1.05 194

1983 43,784

1.26

167

Preliminary indications from LIMRA, based on a sample of companies,

suggest that sales of annuities have continued to rise in 1989, though at

a slower rate than in recent

years.

Page 37 GAO/GGD9O-31 Taxation of Inside Buildup

Chapter 4

The Inside Buildup Debate

The issue of how to treat the inside buildup of life insurance and annu-

ity products has been debated for decades. One argument for keeping

the present tax treatment is that there is no special treatment because

no personal income is truly available in an ongoing life insurance policy.

Other arguments acknowledge the income but suggest that there are

good policy reasons for granting special treatment.

To those who favor full taxation, the fundamental issue is that inside

buildup is income that should be taxed on a similar basis as other earned

income. Other arguments in favor of taxing inside buildup generally

point to evenhanded treatment across financial instruments and institu-

tions or the idea that particular social goals can be better achieved with

more careful targeting of tax preferences or government spending.

Inside Buildup Is

Income

Economic income for a household is defined as the sum of its consump-

tion spending plus the change in its net worth over a period of time.

According to this definition, the interest that accumulates on a life

insurance policy is income-though income that may not be received in

cash. As interest accumulates on a life insurance policy, other income is

not needed to provide for future needs, thus freeing up these other

resources for current use.

Unless some or all of the policy is surrendered or an annuity or loan

received, no cash income is available to the policyholder. One reason for

not taxing the accrual is that no actual cash flows to the policyholder or

annuitant in the absence of some realization, such as surrendering a pol-

icy. Someone may be subject to a tax without having sufficient funds to

pay the tax. This issue arises in the related context of taxing accrued

capital gains. Taxpayers might incur such large capital gains and subse-

quent taxes that they would be forced to sell the assets to pay the taxes.

A related argument of life insurance companies is that they are trustees

for their policyholders, and thus, the interest that builds up is not really

owned by the policyholder or annuitant. While certain charges are

imposed on early surrender, the policyholder has access to the funds

through (1) fully or partially surrendering the policy or (2) borrowing

the funds. The annuitant can take funds out of the annuity, borrow

funds from the annuity, or liquidate the annuity. Even if the policy-

holder or annuitant does not exercise the option of gaining cash, this

does not mean that the interest accrual is not income, only that it is not

cash income.

Page 38

GAO/GGD-WI Taxation

Inside Buildup

w-4

‘he Inside Buildup Debate

Taxing the interest accruing on whole life insurance policies or annuities

would be similar to the current taxation of interest accruing on certifi-

cates of deposit (when the interest is reinvested in the certificate) and

original issue discount bonds. In both cases, the income is taxed even

though no cash is received to pay the tax. Inside buildup is more like

accrued interest than it is like accrued capital gains. Measuring accrued

capital gains, in the absence of a sale of the asset or similar assets, may

be a problem. In addition, capital gains are much more volatile and can

increase or decrease substantially from year to year. Inside buildup is a

steady, measurable increment each year.

Similarly, the prospects for taxpayers not having enough cash to pay a

tax on accrued inside buildup should not be greater than currently

exists for the tax on accumulating interest income. In both cases, funds

may be withdrawn, if necessary, to pay the tax. In addition, inside

buildup is unlikely to generate such a large taxable amount that an indi-

vidual would be forced to surrender a policy to pay the tax. For exam-

ple, a 45year-old with a $100,000 life insurance policy that was

purchased at age 25 and is accumulating interest at 5 percent would

generate interest income of about $850 in that year. In 1984, Treasury

estimated that the average annual inside buildup, for those with cash-

value life insurance policies, was about $365 per family in 1983.

We believe that inside buildup is income and could be taxed without any

more hardship than that imposed by the tax on other forms of interest

income.

Tax Preference May

Because inside buildup is not subject to current taxation, the rate of

Encourage Saving

return to saving through the life insurance policy or deferred annuity is

likely to be higher than if this interest were subject to tax. Whether the

Through Life

rate of return is higher or lower than the after-tax return provided by

Insurance Companies

other savings alternatives is uncertain. Because part of the premium

but Has Little Effect

goes toward purchasing insurance protection, the rate of return for life

insurance is not as high as it would be if alI of the resources were accu-

on Total Saving

mulated. As a pure investment vehicle, standard whole life policies are

not very attractive. However, since they provide insurance protection

along with the investment potential, they can be quite attractive.

If inside buildup were subject to current taxation and this, in turn,

reduced the rate of return on life insurance and annuity products, the

amount saved through the life insurance industry would probably be

reduced. However, total saving is not likely to be affected very much.

Page 39

GAO/GGD9031 Taxation

Inside Buildup

clmpter 4

The Jmdde Buildup Lkbate

The effect on total saving would depend upon whether the funds that

moved out of the life insurance industry were spent or saved elsewhere.

Alternative savings instruments are available other than whole life

insurance or deferred annuities to provide for dependents or for one’s

own retirement. While some funds may be consumed, it is likely that a

substantial part will remain as savings.

One last argument for saving through life insurance is the so-called

“forced saving” argument. People may know that they would like to

save a particular amount or a particular proportion of their income.

However, they may also believe that if they make decisions on how

much to save or consume on a monthly basis, they will always consume

more than they “should.” As a result, they might lock themselves into a

savings plan that will require them to save some amount each pay

period or, at least, make it very difficult to not save some amount each

period. If this forced saving component is important and no alternative

vehicles exist for forced saving, moving funds out of the life insurance

sector could reduce total savings.

Since it is very difficult to quantify the extent to which life insurance

saving is “forced,” it is difficult to evaluate the importance of the

“forced saving” argument. In addition, other ways are available that

allow‘people to force themselves to save, such as retirement plans and

payroll deduction devices. The net effect on total savings of reducing

forced saving through life insurance is, therefore, unclear.

Tax Preference

As a major financial intermediary, the life insurance industry provides a

Increases Long-Term

service by lending for a longer time than it borrows. It provides long-

term financing to those who borrow funds from the industry. At the

Panital lTqm&-on

same time it provides insurance or annuities along with a certain

r mancea by the

amount of liquidity to its lenders who are the policyholders and annuity

owners. This liquidity allows these lenders to receive cash, should they

Insurance Sector but

need it, without being forced to sell other assets and potentially suffer a

Not for the Entire

Economy

substantial capital loss.

However, other financial institutions provide similar fiiancial services.

To argue for special tax treatment for the life insurance industry rela-

tive to other financial institutions, it is necessary to argue that the

insurance industry is better at allocating invested funds from society’s

standpoint than are these other institutions. If the insurance industry

were more efficient and profitable, ensuing returns would reflect this

and the market would provide more funds to the industry without a

P8ge 40 GAO/GGDBO-31 Taxation of Inside Buildup

ChApter 4

The Inside Buildup Debate

need for subsidy or tax preference. If the benefit to society is that the

life insurance industry takes a long-term perspective or that its invest-

ments generate extra returns to society, there would be no reason to

restrict the tax preference to whole life insurance policies or deferred

annuities. The argument for some form of tax preference would also

hold for term insurance, immediate annuities, or any other product sold

by the life insurance industry. The purpose of the tax preference would

be to get more funds into the hands of more efficient investors and not

to limit the preference to only a subset of products.

Overall, no evidence suggests that investment by the life insurance

industry is in any way more socially beneficial than the investment of

other financial intermediaries. Because inside buildup is not taxed as

current income, life insurance companies attract more funds for invest-

ment at the expense of other financial institutions whose interest pay-

ments are taxable to the depositor. Since there does not appear to be any

clear evidence that life insurance companies are more efficient investors

than other institutions, too many resources may be invested in life insur-

ance companies and too few in other institutions.

Insufficient Provision

The primary purpose of life insurance is to replace income lost due to

for Beneficiaries’

the death of the insured. There are a number of reasons why the amount

of insurance purchased may not be adequate for the purpose. If a family

Future Needs Provides

has a low income, for example, it may be very difficult for the family to

Primary Support for

put money aside to provide protection for dependents in case the pri-

mary earner dies. Families with below average income might

Tax Preference

under-purchase life insurance, and dependents in these families could, as

a result, be under-protected. However, this does not appear to be the

CaSe.

In the ownership study done by LIMRA for 1984,69 percent of house-

holds with incomes under $15,000 owned life insurance compared with

81 percent of households at all income levels. While the percentage of

low-income households covered was below average, the amount of cov-

erage by those households with insurance was above average. House-

holds with incomes below $15,000 had coverage that was about 2.8

times annual income, while the average for all households was about 2.5

times income. While fewer low-income families purchase life insurance,

the amounts they purchase- in relation to their income-tend to be

larger.

Page 41

GAO/GGDgo31 Taxation of Inside Buildup

In order for the special tax treatment of inside buildup to provide lower

cost insurance to low-income households, the individual involved must

at least be a potential taxpayer. If the individual’s income is low enough,

there will be no tax liability and, therefore, the tax break will be useless.

The greatest benefit from this tax break would go to those in the highest

marginal tax brackets, and these are not low income households. For

example, Treasury reports that in 1983 fewer than 25 percent of fami-

lies with incomes of $15,000 per year or less had life insurance of the

type involving inside buildup.1 This compares with 42 percent of fami-

lies at all income levels who owned this type of insurance.

In addition, a major source of replacement for the lost income of low-

income groups comes in the form of survivors’ benefits paid by the

Social Security Administration. As is true of all Social Security benefits,

lower income groups get a better return for their contributions than do

higher income groups. Some evidence shows that these benefits have

reduced the amount of life insurance in force (the total face value of

existing life insurance policies), though how much effect it has had on

low-income groups is unclear.

Other concerns about the adequacy of life insurance protection have less

to do .with household income. One important concern is that people do

not have sufficient foresight to plan for the contingencies of the future.

It is difficult to know how much income one will have in the future, and

how many people will be dependent on that income. While additional

insurance can usually be purchased, it is generally more expensive the

longer the delay. It may be difficult to know how much insurance is

required to allow dependents to maintain a particular standard of living

due to changes in inflation rates and other macroeconomic changes.

Also, since most life insurance is purchased by the insured rather than

by the potential beneficiary, dependents may find that the amount of

insurance purchased is insufficient for their needs.

Although a number of studies have been done on the adequacy of life

insurance coverage, the evidence regarding the adequacy of this cover-

age is inconclusive. One study indicated that low-income groups had

adequate protection-at least as defined by the study and for the period

examined-as a result of both purchases of life insurance and the Social

‘Tax Reform For F alrness,

&ember 1964, p. 262.

Simplicity, and Economic Growth, Vol. 2 Department of the Treasury,

Page 42

GAO/GGDfXMl Taxation of Inside Buildup

chapter 4

The Inside Buildup Debate

Security system and that higher income groups also had sufficient pro-

tection. A broad range of middle-income people, however, did not appear

have

adequate coverage.

According to an ownership study by

the

Life Insurance Marketing

Research Association, middle-income families with life insurance had

protection that averaged about 2.4 times their annual income. This ratio

is less than the coverage ratio recommended by some industry authori-

ties, which was 4 to 5 times annual income. In addition, since about 90

percent of middle-income households had life insurance, for all middle-

income families, the ratio of life insurance coverage to annual income

was closer to 2. A more recent study indicates that coverage may be

adequate when the costs and benefits of insurance are carefully com-

puted. If the adequacy of existing coverage is difficult to evaluate, it

would be even more difficult to estimate

the

effect

that

taxing inside

buildup would have on life insurance coverage.

Policy Loans Defeat

Purpose of Life

Insurance and Should

Be Taxed

Outstanding policy loans reduce the value of a life insurance policy’s

death benefit; thus, loans not paid back before

the

death of

the

insured

defeat the purpose of life insurance. Because the company cannot force

the policyholder to repay the loan-it is after all

the

policyholder’s

money-loans could be restricted or considered realizations of income

first and considered principal second. This practice would make the tax

treatment of life insurance consistent with that of other forms of

deferred compensation, including annuities. However, restricting the

ability to borrow against policies may reduce the demand for those poli-

cies. If existing life insurance coverage is inadequate, this could make

that coverage even less adequate.

In 1988, Congress restricted borrowing on certain types of life insurance

policies. One purpose of these restrictions was to limit the potential for

borrowing on single premium life insurance policies at zero or very low

rates. Congress imposed the restrictions not by explicitly limiting the

ability to borrow against life insurance but by altering

the

definition of

what constitutes life insurance. The effect was to create a type of policy

with very restrictive borrowing privileges, much like those of annuities.

While these changes limited borrowing on policies with fewer than

seven annual premiums, they did not directly deal with

the

broader

problem of borrowing against the cash value of any whole life policy.

This borrowing is the one tax advantage that life insurance retains over

other forms of deferred compensation. In

this way,

the life insurance

Page 43

GAO/GGDW31 Taxation of Inside Buildup

CM=4

The Indde Buildup Debate

industry could be said to have a tax advantage over other industries

offering deferred compensation instruments.

Conclusions

ties, the federal government forgoes $6 billion a year in potential tax

revenue. While imposing a tax on the inside buildup could pose cash

flow problems for some taxpayers because they will be taxed on income

that they

have not yet received in cash, the buildup is income and there-

fore could be part of the income tax base.

The only reason for not taxing inside buildup that we found to have

merit is that doing so would reduce the amount of life insurance cover-

age that some people buy. Protecting survivors against income loss is a

goal that society has traditionally supported. The primary question then

is whether the increased revenue generated from taxing inside buildup

would outweigh the costs to society of reduced insurance protection,

including the possibility of direct government provision of income pro-

tection for dependents. Because patterns of life insurance ownership

and the types of products available can change, Congress may wish to

periodically reexamine its policy decision to forgo taxing inside buildup,

weighing the social benefits against the revenue loss.

It may be preferable to give the tax advantage to those who would sub-

stantially reduce their coverage in the absence of the tax advantage, and

not give the advantage to those who would purchase sufficient insur-

ance even without the incentive. Unfortunately, it is very difficult to

provide a targeted incentive for something that would not have occurred

without the incentive and not to provide incentives for activities that

would have occurred anyway.

High-income people would probably be able to protect their dependents

without any tax preference and lower income groups are usually pro-

tected by Social Security benefits. In Tax Reform for Fairness, Simplic-

ity, and Economic Growth, the Treasury Department proposed a way of

limiting the tax preference for inside buildup by including the cash

value of life insurance within the IRA ceiling. others have proposed lim-

iting the amount of tax-deferred interest that a taxpayer may claim.

Restrictions such as these, though possibly cumbersome and difficult

administer, are feasible and would probably save the federal govem-

ment some revenue. We have not done any analysis of the relative costs

and benefits of such restrictions and, as a result, cannot evaluate

these

proposals. Congress may wish to examine this area if it chooses to

Page 44

GAO/GGDWl Taxation

Inside Buildup

Chpm4

‘he Inside Buildup Debate

revisit the policy decision to grant preferential tax treatment to inside

buildup.

The effect of this special tax treatment on the national savings rate is

ambiguous. While the after-tax rate of return on funds invested in life

insurance and annuity products is probably higher than it would be if

taxable, it is not clear that it is higher than after-tax rates on taxable

instruments that do not provide insurance or annuity protection. Even

so, the effect of after-tax rates of return on saving is, in general, not

clear. Only if a substantial amount of the saving is “forced” is there

likely to be much in the way of additional saving. No evidence shows

that the life insurance industry is any better than any other segment of

the financial sector at making efficient investment decisions.

The inside buildup on life insurance and deferred annuities is treated

similarly, under current tax law, as long as the funds remain in the

product. However, tax law treats funds that are withdrawn or borrowed

from a life insurance policy differently from funds withdrawn or bor-

rowed from an annuity. The proceeds of a life insurance policy can be

borrowed unconditionally and without tax, while the proceeds of

deferred annuities can only be borrowed if a tax and a penalty are paid.

Other deferred compensation instruments allow borrowing without tax-

ation only under certain stringent conditions, otherwise a tax and pen-

alty are imposed.

Until now, Congress has chosen to deal with concerns about potential

misuse of the tax preference associated with inside buildup by narrow-

ing the definition of what qualifies as life insurance. The definitional

approach involves two dangers. F’irst, the definition may not be narrow

enough. Policies may qualify that are primarily oriented toward produc-

ing investment returns rather than insurance protection. Second, the

definition could be too narrow. Products serving a legitimate life insur-

ance need may be disqualified.

An alternative to the definitional approach would deal with the con-

cerns more directly. Taxing the accumulated interest would remove the

need for defining life insurance in the tax code, since there would no

longer be any advantage to qualifying as insurance. The effect of this

would be an extreme version of the overly strict definitional approach-

that is, the tax preference would not be available for products that

serve a legitimate life insurance purpose. An alternative would be to

limit or eliminate the ability of policyholders to gain access to their

Plrge 45 GAO/GGD!XMl Taxation of Inaide Buildup

clupter4

The hide Ekdldnp Debate

inside buildup without paying a tax. Taxing or placing limits on borrow-

ing is a way of achieving these goals.

The ability to borrow against a life insurance policy is an attractive fea-

ture. Limitations on that feature may cause some buyers to reconsider

the amount of life insurance that they wish to purchase. Unlimited bor-

rowing allows the policyholder access to income without paying any tax

and reduces the death benefit. Thus, we believe that borrowing against

life insurance proceeds should be considered a realization of income sub-

ject to tax. The buildup is no longer inside the policy, and the basis for

tax deferral no longer exists. If this serves to reduce borrowing, death

benefits will be protected against what could be perceived as shortsight-

edness on the part of the policy owner. If it does not reduce borrowing,

income will be taxed as it is realized. An added advantage of taxing life

insurance borrowing is that it would reduce the incentive to construct

life insurance policies, like single premium life policies that were

designed for investment and not insurance purposes. Since repayment of

borrowed amounts restores the death benefits, any amount that was

included in taxable income when borrowed should be deductible if and

when repaid.

Recommendation

Because the pattern of policy usage as well as the type of products

offered can change, Congress may want to periodically reconsider its

policy decision to grant preferential tax treatment to inside buildup,

weighing the social benefits against the revenue forgone.

If Congress decides not to tax inside buildup, then

GAO

recommends that

Congress eliminate tax-free borrowing of life insurance proceeds. Any

borrowing of these proceeds should be considered a distribution of inter-

est income. To offset the advantages of accruing interest income without

tax, a penalty provision needs to be added to the regular tax. Since

repayment of the amount borrowed restores the death benefits, any

amount that is taxed when it is borrowed should be tax deductible if

subsequently repaid.

Comments

GAO

obtained oral comments from industry representatives on this

report. Industry representatives stated that in their opinion, the current

tax treatment of inside buildup is justified. They believe that recent

changes in the tax laws have remedied serious abuses. They said that

traditional life insurance products are not overly investment-oriented,

although some of the single premium policies may have been. The

Page 48

GAO/GGIM30-31

Taxation of hide Buildup

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Tlte hide

Buildup

Debate

changes made in 1988, however, effectively closed any loopholes. In

their view, loans are a legitimate part of the life insurance product and

are generally used to serve important social goals, such as financing a

home or paying college tuition. Therefore, there is no need to place any

restrictions on these loans.

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Appendix

Cakulation of Excess Premiums on Whole

Life Insurance

Excess premiums arise in the early years of a whole life insurance policy

because the annual premium is greater than the cost of the actual insur-

ance coverage. As shown in chapter 2, the excess premiums are invested

by the insurance company and earn interest income for the policyholder;

the sum of the excess premiums and interest income built up is a policy’s

cash value. The face value less the cash value is the amount of actual

insurance coverage provided by the policy for that year. The premium

paid less the cost of the actual insurance coverage for a given year

equals the excess premium for that year. The cost of the actual insur-

ance coverage for a given year is the premium that would have to be

paid for a l-year term policy giving the same coverage. Table I.1 shows

how the excess premiums grow in the early years of a policy, when the

cost of the actual insurance coverage is less than the premium, and then

become negative as the cost of the actual insurance coverage becomes

greater than the premium. The calculations are based on the $100,000

annual premium whole life policy presented in chapter 2.

Table 1.1: Calculation of Yearly and

Cumulative Excess Premiums on a

$1 W,ooO Annual Premium Whole Life

Policy

Age

Annual

premium

$676

676

Actual

insurance

coverage

$99,466

92,381

82,095

68,509

52.344

cost ot

insurance

$168

186

356

683

1.191

Annual Cumulative

excess

premium premiums

$508 $508

490 5,609

320 9,699

(7) 11,326

(515) 8.335

75 676 35,759 2,186 (1,510) (2,169)

85 676 22,243 3,240 (2,564) (22.936)

95 676 10,717 3,368 (2,692) (51,258)

99 676 0 0 0 (58.557)

The annual excess premium begins at $508 at age 25 and declines gradu-

ally over the years until it turns negative at age 55. At this age, the

cumulative excess premiums reach a maximum of $11,326. After age 55,

the cost of the actual insurance coverage is greater than the annual pre-

mium, and the annual excess premium turns negative. At this time, the

cumulative excess premiums are used to supplement the annual pre-

mium. By age 75, however, the cumulative excess premiums are used

up; the inside buildup (interest income) is then used to supplement the

annual premium in order to cover the cost of the actual insurance

coverage.

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GAO/GGD9%31 Taxation of Inside Buildup

Appendix II

Major Contributors to This Report

General Government

Paul L. Posner, Associate Director, Tax Policy and Administration Issues

Natwar Gandhi, Assistant Director

Division, Washington,

Larry Korb, Assignment Manager

D.C.

Tom McCool, Economist-in-Charge

MacDonald R. Phillips, Economist

Bill Simpson, Actuary

(268401)

Page 49 GAO/GGD9031 Taxation of inside Buildup

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