Advanced Underwriting Consultants

Question of the Day – March 18

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question:  I’m presenting a universal life insurance proposal to a prospect, and am having trouble with explaining guideline premium limits on the illustration.  Can you help sort it out?

Answer:  Most flexible premium life insurance illustrations show three different premium limits for a particular proposal:  guideline single premium, guideline level premium and seven-pay guideline.  These limits are calculated using a number of factors, the most important of which are the insured’s age, the policy’s face amount and the insured’s risk classification.

If the policy owner puts more premium into a life policy than is allowed by the federal guideline premium, the policy is not considered life insurance anymore.  If a policy is not life insurance, the cash value growth each year is taxable, and the death benefit is also taxable.  The guideline premium limit for a given life policy is the greater of the guideline single premium or the cumulative guideline level premium.

These Section 7702 tax results are so severe that life companies do not permit policy owners to violate federal guideline premium rules.

If a policy owner puts more premium into a life policy than is allowed by the seven pay limit, the contract will become a modified endowment contract (MEC).  Lifetime distributions from a MEC policy are treated less favorably from a tax perspective than from a “normal” life policy, but the death benefit would still be income tax free.  Life companies usually do permit their life policies to become MECs.

Here’s an example of how the limits might apply for a particular policy.  Assume that the premium limits shown on the illustration are guideline single ($13,500), guideline level ($1,500) and seven pay ($2,500).  Here’s a chart that helps show how the numbers interact:

Year Guideline Single Cumulative Guideline Level Cumulative Seven Pay
1 13500 1500 2500
2 13500 3000 5000
3 13500 4500 7500
4 13500 6000 10000
5 13500 7500 12500
10 13500 15000 Test ends
15 13500 22500 Test ends

Say that the illustration shows the client paying a one-time premium in the first year of $12,000.  The first test is whether the premium is more than the greater of the guideline single or cumulative guideline level.  While the premium is more than the cumulative guideline level, it is less than the guideline single.  Therefore, the premium is allowable for a life insurance policy.

The second test is whether the premium is in excess of the cumulative seven pay limit.  It clearly is, so the policy will be a MEC.

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