Due to low prevailing interest rates, the federal government has restricted the ability of industry experts to show the robust rates of return that LIRPs are capable of.
When the Consolidated Appropriations Act was passed in the final hours of 2020 it amounted to a Christmas miracle, and it will be immensely positive for LIRPs and will position them to thrive in an environment of low-interest rates.
Section 7702 is the section of the tax code that governs the tax treatment of life insurance and it hasn’t been changed in decades. The tax limitations within the section are calculated by asking a simple question. Namely, at what premium level will the policy stay in force based on the life insurance expenses and assumed interest rate?
Baked into the 7702 code was the assumption that your cash value would grow at either 6% or 4%, depending on premiums.
When you put money into a life insurance policy, there is a relationship between how much money you can contribute and the death benefit that you are purchasing. This is because the IRS wants to define how much tax benefit you can get, this was directly affected by the assumed interest rates.
On page 4923 of the Consolidated Appropriations Act that was passed at the last moment of 2020 we find a hard coded rate of 2% for 2021 and a floating rate based on prevailing interest rates in 2022 and beyond.
This essentially means that you are going to be able to put considerably more money into a life insurance policy for the same death benefit. The expenses of these life insurance policies are relatively fixed, which means you are incentivized to put in as much money as you can to maximize your return.
For people between 40 and 55, the amount you can contribute has increased anywhere from 60% to 100% with triggering a modified endowment contract which would result in the distributions becoming taxable as regular income.
The end result is that LIRPs are going to become more efficient going forward. Bobby Samuelson runs some calculations in his article to illustrate the differences between the past regulations and the recently passed act.
Using the new 2% hard coded interest rate, the scenario illustrates that you could contribute significantly more money while still maintaining the preferential tax-free treatment, while also increasing the rate of return. This allows you to also increase the distributions over the life of the program.
Because of this act, all policies will now have more efficient cash value growth, which means the LIRP will be an even more attractive alternative to those who are using it as an accumulation and distribution tool.
Other countries will eventually stop loaning the US money as we experience a sovereign debt crisis, which means that interest rates won’t stay low for very long. The long and short of it is we should feel better and more optimistic about LIRPs now than we ever have.
The ACLI and Finesca were primarily responsible for the new act by persuading legislators to lower the hard coded interest rate and linking it to prevailing rates in the future. This change will not affect any existing LIRPs that are currently in force but there is still some uncertainty regarding whether increasing the death benefit of an existing policy will be affected by the new legislation.
This is great news for anyone who has a LIRP or is considering one to maximize their tax-free benefits.
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