Section 7702 Changes: Is Whole Life Insurance Still A Good Savings Vehicle?

By now, advisors in the industry are well aware that the life insurance industry is going through changes. The end of 2020 introduced recent changes to Section 7702 of the tax code, which hasn’t been touched in decades. While we've read mixed interpretations, we’re looking at the whole truth.

The truth is, first and foremost, that whole life insurance is an incredibly certain asset. Insurance companies have always met guarantees and have a more than century-long track record of paying non-guaranteed dividends. Even through world wars, recessions, and the Great Depression. It has remained certain and reliable in the face of even the worst economic scenarios. 

Guarantees are the backbone of whole life insurance and allow policies to have such accelerated growth. Based on what we know of upcoming changes, we believe guarantees will be strengthened. This will allow new policies to thrive in even the lowest interest rate environments. 

Section 7702

Section 7702 is the portion of the tax code that determines how life insurance will be taxed. These regulations determine what is, and is not, a life insurance contract. This section is actually the groundwork for MECs, identifying how much premium is too much premium, and therefore a misuse of the tax advantages of whole life insurance. 

The MEC designation allows the IRS to better prevent money laundering; since any dirty money put into a policy is then safe from the IRS. It also prevents tax evasion. Otherwise, people could fund their insurance in one lump sum to grow tax-deferred for life, without the IRS being able to reach it. In order to preserve the integrity of life insurance as, well, insurance, the IRS created parameters for funding the contract. 

Over-fund an insurance contract, and it turns into a Modified Endowment Contract. As a MEC, it lacks many of the attractive tax benefits of whole life. Thus, is an incentive for people to use their insurance as insurance first.

New MEC Limits

Because of the low-interest rate environment we’re in, companies have realized that the 4% floor is unsustainable. Organizations like ACLI and Finesca lobbied for such changes, in order for insurance companies to survive. Primarily, changing what constitutes a MEC, and how to calculate that. 

In other words, the IRS changed the minimum guarantee from 4% to 2%. This means that companies can better navigate low-interest rates. In turn, this changes how insurance companies will calculate their premiums. The result is that companies can actually charge higher premiums for the same face value of a policy than they could previously, without a policy becoming a MEC.

For obvious reasons, higher premiums can be a pain point for potential clients. However, higher premiums and a lower guaranteed floor allow companies to be more conservative during tough financial climates. In turn, companies can better balance their guarantees with their non-guaranteed dividends.

When working with a client, seek to identify the purpose of their money and their assets–and seek to fulfill that purpose. Premiums, for example, help you build cash value. While they are designed first to cover the costs of insurance, we cannot deny this fact. If your premium dollars are not going directly into your client's cash value in the first ten years or so, then they are directly funding the guaranteed death benefit. No money is ever wasted—it all fulfills a purpose.

Ask your clients—are they seeking to build wealth? Are they looking to create a legacy? Do they want an asset with certainty (as opposed to risk)? Maybe they want liquidity, or protection. In any case, whole life insurance can check all of these boxes. Even considering these upcoming changes, life insurance still provides these elements and more–and can still beat the guarantees of a bank account. 

The overarching benefit of these seemingly negative changes is that companies will be able to continue to check all these boxes, even in the toughest of economies. 

Why We’re Not Concerned

Many people—insurance agents and clients alike—seem uneasy with these changes, because of the further reduction of the minimum guaranteed cash value. After all, a common sales pitch advisors like to throw around is the “guaranteed 4%” (despite that being a Gross 4% to begin with). Now, it’s possible to interpret the new minimum 2% as less desirable or useful—which isn’t good for sales. 

Here’s why we’re not concerned…

The purpose of the minimum guaranteed floor is to allow insurance companies to properly calculate policy costs that would avoid a policy becoming a MEC. While companies can offer more than the minimum, this usually follows federal interest rates. Higher interest rates mean higher guaranteed and non-guaranteed increases.The floor also means that in a low-interest rate environment, like we’re in right now, companies are having a harder time meeting the minimum guarantees. In turn, it makes paying dividends even more difficult.

By lowering the floor, companies can still meet all of their contractual guarantees, and likely be able to pay dividends in a low-interest rate year. This only further extends the certainty of insurance companies and allows them to fulfill their purpose. Otherwise, companies are put at unnecessary risk by trying to meet a 4% floor in a 1% interest environment. While they might be able to maintain it for a while, it could have adverse effects in the long run. 

(It’s important to note that the 4% floor is a gross percentage, not including policy costs. Illustrations portray net cash values, regardless of whether you’re looking at guaranteed or non-guaranteed values.)

While guarantees may be less attractive, we’re optimistic that as we move into a better interest-rate environment, non-guaranteed dividends will also be higher. At the end of the day, whole life insurance is rooted in the certainty of its guarantees, something that no other asset class has. Although the Federal Reserve may continue to print money and pump it into Wall Street, the risk has not been eliminated. The changes in the insurance industry, on the other hand, will have tangible effects on longevity. 

How Will This Change Affect New Policies?

As of writing this article, insurance companies have not yet begun to implement this Section 7702 change. In the coming months, we may begin to see companies changing illustrations based on these new guidelines,. When that happens, we’ll make an update. It could be some time before sweeping change occurs, as current policies are still meeting guidelines since the floor was decreased, not increased. 

Another benefit of this change is that in-force policies will not be affected. Any contractual obligations will still be met, and premiums will not change for in-force policies. When working with new clients, many may not know about these changes occurring. Overall it will have no effect on the actual function of whole life insurance. 

If you find concerned clients, urge them to focus on the increased strength of whole life. Bring the discussion back to purpose; and ensure that insurance checks all or most of their boxes, to determine if it will be a good fit. 

To brush up on your personal knowledge of Truth Concepts, and how to use it with your clients, come to our next 3-day Truth Training event.

4 Responses

  1. While it seems like a big change coming for whole life in the US, we in Canada have never relied on the 4% guarantee since our minimum guarantee is much lower. This allows our insurers more leeway in the dividend payments as you mention which more than makes up for the lack of a higher guarantee. Dividend interest rates for the companies we work with are currently between 5 – 6%.

    1. That’s great to hear, Will. Hopefully that fact alone can provide some reassurance for those who are wary of what’s in store. We agree and think it’ll really strengthen the industry for years to come.

  2. Based on agents’ reactions to Ohio National’s recent demutualization announcement, it becomes apparent that our over-reliance on illustrated current dividends has lulled us (and our clients) into a false sense that their and our policies were somehow exempt from companies bottom line decisions and government interference . Watching what we say to clients prior to selling regarding current and inevitable future realities might go a long way in having to “eat crow” down the line.

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