Key Laws Governing Insurance

TEFRA (Tax Equity and Fiscal Responsibility Act of 1982)

TEFRA is the federal law that established the first official legal definition of "life insurance" for tax purposes. Before TEFRA, universal life policies were used primarily as tax-free investment accounts with a minimal "token" death benefit. TEFRA ended this by mandating that a policy must maintain a specific ratio of "actual insurance" relative to its cash value.

TEFRA (Section 7702) tests require a policy to maintain a specific relationship between the cash value and the death benefit. When you buy a policy, you must choose one of these two tests; you cannot change it later.

1. Cash Value Accumulation Test (CVAT)

CVAT is simpler and often used for Whole Life or Legacy-focused policies. It requires that the cash value never exceed the amount needed to fund all future benefits.

• The Scenario: A 45-year-old buys a policy with a $150,000 cash value.

• The "Corridor": If the IRS-mandated corridor for their age is 20%, the death benefit must be at least $180,000 ($150,000 + 20%).

• The Result: If the cash value grows to $200,000 due to high interest or a "dump-in" payment, the insurance company must automatically increase the death benefit to $240,000 to remain compliant.

• Best for: People who want to put in large sums of money early or who want the death benefit to grow significantly as they age.

2. Guideline Premium Test (GPT)

GPT is the "two-pronged" test most common in Universal Life policies. It limits the premium you can pay rather than just the cash you can hold.

• Prong A (Premium Limit): If the IRS calculates your "Guideline Level Premium" as $20,000/year for a $1 million policy, you cannot pay more than that amount annually.

• Prong B (The Corridor): Even if you stay under the premium limit, the death benefit must still stay a certain percentage above the cash value. This percentage "shrinks" as you get older.

• The Result: If you try to pay $25,000 into the policy above, the insurance company will likely refund the extra $5,000 to you to prevent the policy from failing the test and becoming taxable.

• Best for: People who want to maximize cash accumulation with the lowest possible insurance costs (as GPT corridors are generally "thinner" than CVAT corridors).

Aside from TEFRA (which defined what life insurance is), two other massive pillars of tax law dictate how your legacy policy will behave. If TEFRA is the foundation, DEFRA and TAMRA are the walls and the roof.

DEFRA (Deficit Reduction Act of 1984)

DEFRA tightened the rules established by TEFRA, specifically focusing on the Guideline Premium Test (GPT) and the "corridor" of protection.

• The "Corridor" Rule: It mandates that a policy must maintain a minimum "amount at risk." For example, at age 40, your death benefit might be required to be 250% of your cash value. As you age (e.g., age 75), that required corridor shrinks (perhaps to 105%).

• Legacy Impact: This ensures that even if you "overfund" your policy for cash growth, there is always a tax-free death benefit for your heirs.

TAMRA (Technical and Miscellaneous Revenue Act of 1988)

This created the 7-Pay Test and the Modified Endowment Contract (MEC) status.

• The "7-Pay" Limit: Before TAMRA, people were dumping millions into "Single Premium Life" policies to hide cash from taxes. TAMRA put a stop to this by saying: if you fund your policy faster than what it would take to pay it off in seven equal annual installments, you lose your tax-free withdrawal privileges.

• Legacy Impact: If your goal is purely a legacy gift, TAMRA matters less. A "MEC" policy still pays out a tax-free death benefit; it only taxes you if you try to spend the money while you're alive.

Summary of the "Trilogy"

• TEFRA: Does this count as life insurance?

• DEFRA: Is there enough "insurance" relative to the "cash"?

• TAMRA: Did you put the money in too fast?

Modified Endowment Contract (MEC)

The Core Rule

The rule determines if a permanent life insurance policy will be reclassified as a Modified Endowment Contract (MEC). To avoid becoming a Modified Endowment Contract (MEC), a life insurance policy must pass the "7-pay test," but it also remains subject to the cash value corridor requirements of IRC Section 7702.

The "Corridor" Requirement

The corridor requires that the death benefit always stay at least a certain percentage above the cash surrender value. This prevents the policy from essentially becoming a tax-sheltered investment account with negligible insurance.

IRS Cash Value Corridor Factors (Applicable Percentage)

If the cash value of a policy approaches the death benefit, the death benefit must increase based on the following percentages of the cash surrender value, which decline with age:

Key MEC Considerations

The 7-Pay Test: The IRS calculates the maximum amount of premium you can pay into a policy during its first seven years.

The Threshold: If the cumulative premiums paid at any point during these first seven years exceed the amount needed to fully fund the policy in seven equal annual payments, the policy will be "MECs".

Resetting the Clock: Making a "material change" to the policy—such as increasing the death benefit or adding certain riders—can trigger a new seven-year testing period.

Consequences of Becoming a MEC

Once a policy is classified as an MEC, the change is permanent and irreversible. It loses several key tax advantages:

LIFO Taxation: Withdrawals and loans are taxed on a "last-in, first-out" (LIFO) basis, meaning gains (interest) are taxed as ordinary income before you can access your tax-free principal.

10% Penalty: If you take a distribution (withdrawal or loan) before age 59½, you may face an additional 10% federal tax penalty on the taxable portion. This penalty may not apply if the policyholder is disabled.

Taxable Loans: Unlike standard policies, where loans are generally tax-free, MEC loans are treated as taxable distributions if there is a gain in the policy.

What Stays the Same

Despite the tax changes on withdrawals, two major benefits typically remain intact:

Tax-Free Death Benefit: The money paid to your beneficiaries upon your death remains generally free of federal income tax.

Tax-Deferred Growth: The cash value within the policy continues to grow without being taxed annually.

Most insurance companies will provide an illustration or alert you if a planned payment would trigger MEC status.

Always request a MEC limit illustration before making a large unscheduled premium payment or 'dump-in'.

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