life insurance policies have tax rules

TEFRA DEFRA TAMRA: How Taxes Effect Life Insurance

Life insurance enjoys some unique tax benefits, but it also faces limits imposed by legislation we know as TEFRA DEFRA and TAMRA.  These pieces of legislation established specific guidelines as to what you can and cannot do with life insurance.

Each of these pieces of legislation creates rules that agents, policyholders, and people looking at whole life or indexed universal life insurance (or any UL product) should know.

And failing to understand these rules could cause all sorts of headaches in the future; it could also lead to mistakes made in the life insurance design process.

Mistakes that will cost policyholders in adverse tax consequences or the loss of additional value.

These three pieces of legislation established industry terms like 7702 Qualification, Cash Value Accumulation Test (CVAT), Guideline Premium Test (GPT), Corridor Test, 7-Pay, and Modified Endowment Contract (MEC).  This post explains what all of these mean and walk you through some additional guidance on how the rules can help or hurt your life insurance policy implementation.

But first, it helps to understand…

The Tax Benefits of Life Insurance

Life insurance has more than a handful of tax-advantaged benefits but the few relevant in the context of wrapping our heads around TEFRA DEFRA TAMRA etc. are:

  • Tax-deferred growth of cash values
  • First In First Out (FIFO) distribution of cash values
  • Income tax-free loans
  • Income tax-free death benefit

Life insurance has enjoyed the majority of these benefits for decades, but over the last three decades, the rules changed to limit the use of life insurance with the express intention to act as a tax shelter. 

So while the rules about how life insurance values flow through the U.S. tax system haven't changed in a while, the way you pay money for a policy has changed.

Life Insurance Before the Rules

There was a time when you could…theoretically…place an unlimited amount of money into a life insurance contract.  No rules existed that prevented it, and if you did this, you’d still reap the tax benefits listed above that life insurance enjoys.

The only problem was…no mechanism existed to allow such a feat.  Life insurance was super rigid and did little to permit the payment of additional sums of cash into a policy.

But then the 1970's came along and with this decade came an incredible industry innovation–the introduction of Universal Life Insurance.  It's hard to appreciate what universal life insurance brought to the table if you entered the industry after its inception.

But imagine, if you will, a world where you're only permanent life insurance options are whole life insurance (pretty much as we know it today just missing a few riders, chief among them the paid up additions rider), endowment contracts, and this product that probably wasn't going anywhere called variable life insurance.

All three products have the same basic features, a fixed premium amount required over a certain period of time that could not be changed without also changing the death benefit on the policy. 

No option to add more money to the policy, and certainly no option to skip payments or reduce the premium.

Then comes universal life insurance. 

A product with new and groundbreaking (at the time) key features. The most critical among them…

No fixed premium.

There’s just an ongoing expense deduction that must be met either with premiums paid by the policyholder or by cash held in the policy.  This meant that the policyholder was free to pay as much or as little as he/she saw fit. 

Just speculating here but the industry's original intention was probably more focused on giving policyholders discretion over their payment amount.  The 70's were a liberating time after all.

But then a certain reality set in and the shrewd among the insurance crowd noticed an opportune side effect of this new found freedom to pay when you wanted in whatever amount you wanted. 

If you paid more, like a lot more than you needed to, then you could house a lot of cash inside a life insurance policy.  And housing a lot of cash inside a life insurance policy meant you could take advantage of the tax-friendly features of life insurance.


It didn't take long for skilled agents to shout the benefits of this new product from the rooftops and this began a practice of purchasing a small universal life insurance policy (e.g., a few thousand dollars in death benefit) and making substantial (e.g. tens or hundreds of thousands of dollars) cash payments towards the policies.

This led some to question if this new product should even be considered life insurance at all.

Cue the sad music.

Congress Act 1: The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982

Passage of the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982 established that universal life insurance was, in fact, life insurance. But the law did define some characteristics of life insurance that must be present.

Beyond this, TEFRA is a mostly dull piece of legislation concerning life insurance.  So while many in the life insurance industry likely held their breath while this legislation was hammered out, it's ultimate impact was minimal.  It wasn't until two years later that legislators used this legislation and new legislation to slap the first set of handcuffs on life insurance.

Congress Act 2: The Deficit Reduction Act (DEFRA) of 1984

The Deficit Reduction Act (DEFRA) of 1984 coordinated with language laid out in TEFRA from two years before to establish specific rules about what life insurance was and what life insurance was not.

More specifically, upon DEFRA's passage, we now had specific limitations on premium size relative to an outstanding death benefit that qualified or disqualified a life insurance contract as life insurance.

It's easiest to think of these limitations as tests in the sense that failing the tests means the premium amount is outside the allowable limit, and the limit is a function of the size of the death benefit.

There are actually two tests, the Cash Value Accumulation Test (CVAT) and the Guideline Premium Test (GPT).

The Cash Value Accumulation Test (CVAT)

The CVAT was established mostly to handle how whole life insurance policies qualified as life insurance.  The test is rather straightforward in the sense that it merely tests the level of cash that can exist inside a life insurance policy relative to the outstanding death benefit. 

So long as this line is not crossed, the policy in question passes the test and is a life insurance contract.

Guideline Premium Test (GPT)

The GPT was established mostly to handle how universal life insurance policies qualified as life insurance (though universal life insurance can qualify as life insurance using the CVAT as well).

The test has two specific parts.

Step One is an amount of premium that a policyholder is allowed to pay into the policy relative to the death benefit. 

For example, if the policy has a $1 million death benefit and the calculated guideline premium is $20,000 each year, the policyholder can place no more than $20,000 into the policy in any given year.

However…there are some exceptions…

There's an allowance for both a one-time payment and an ongoing annual payment.  If the policyholder chooses to make the one-time payment, that would be all the premium he/she would be allowed to pay towards the policy.

Step Two is a ratio of cash value to the outstanding death benefit that decreases as the insured gets older.  This is sometimes referred to as the corridor and why GPT is sometimes known as the corridor test.

What Happens If You Fail the Test?

Failing the test to qualify as life insurance means that policy is no longer considered life insurance.  Instead, U.S. Tax Law treats the contract as if it were a taxable account much like a general brokerage account or savings account.

Any gain in the policy becomes immediately taxable as ordinary income.  The earnings in the policy each year are taxable in that year just like a standard savings account or CD. 

Death benefit proceeds are only income tax-free to the beneficiary for the portion paid to the beneficiary that represents raw death benefit.  Lastly, because the contract no longer qualifies as life insurance, the policyholder cannot choose to transfer the funds in the policy to another life insurance policy through a tax-favorable 1035 exchange.

These rules sought to severely diminish the use (some would say abuse) of life insurance solely as a tax shelter, and they did a pretty good job of minimizing this behavior.  But these rules didn't entirely stop the practice, and Congress felt compelled to act one last time.

Congress Act 3: The Technical and Miscellaneous Revenue Act (TAMRA) of 1988

The Technical and Miscellaneous Revenue Act (TAMRA) of 1988 laid out one additional restriction on life insurance.  A new test that limited premiums paid to a life insurance policy to essentially the premiums needed to cover all guarantees of the contract spread out over a seven-year period–this is why we often call it the 7-Pay Test.

If a policyholder violated this rule by paying more than this amount, he or she didn't lose his/her policy's status as life insurance per se.  Instead, the policy was reclassified as a Modified Endowment Contract (MEC).

It's important to understand that a MEC is still a life insurance contract. 

But now it’s a life insurance contract that loses the First In First Out (FIFO) tax treatment and instead must use Last In First Out (LIFO).

Being forced to use the LIFO method comes with an income tax liability to any distribution beyond tax basis including loans and collateral assignments.

Cash values still accumulate tax-deferred, and the death benefit is still income tax-free to the beneficiary with a MEC.  Also because a MEC is considered life insurance it is still eligible for the tax favorable 1035 exchange to a new life insurance policy. 

However, because the funds received through 1035 come from a policy that violated the TAMRA test, the new policy will automatically fail the test and will also be a Modified Endowment Contract.

Practical Applications of TEFRA DEFRA and TAMRA Tests

For those looking to buy plain vanilla, no bells or whistles, whole life insurance for the sake of the death benefit, none of this matters much.  It's nearly impossible that such a scenario would come anywhere close to violating either test.

But for those of you that offer your clients life insurance with the intention to maximize cash value build up, understanding these rules is a must. 

So when you notice a warning message in any sort of illustration that notes the policy violated the CVAT, GPT, or TAMRA 7-Pay Test in a particular year, you need to be especially sure that you intend to put a policy in force in such a fashion. 

Otherwise, further adjustments are necessary to allow the planned premium into the policy without possible disastrous consequences.

Failure is Most Often NOT an Option

It is extremely rare for a life insurance company to allow a policyholder to violate the TEFRA DEFRA qualifying test.  No company we are aware of (outside of Gerber) will put a policy in force if it fails the test.

Life insurance companies will also most often reject premium payments if the amount violated the TEFRA DEFRA qualifying test.

A lot of this has to do with the additional administrative issues posed by failure.  If a policy fails and is reclassified outside of a life insurance contract, it's now up to the life insurance company to generate things like 1099's each year to report the earnings on the policy.  This is an additional task most life insurers want no part in.

Modified Endowment Contracts Don’t Happen Accidentally

Insurers also test policies for TAMRA compliance when receiving premiums.  If the premium payments violate the TAMRA limit, the company will notify the policyholder and allow him/her to take back the payment amount that fails the test (be responsive if this happens, time is of the essence).

Insurance companies usually require additional attestation paperwork from the policyholder should he or she choose to intentionally put a MEC in place.

Single premium life insurance policies are a perfect example of this. 

Since single premium policies will always violate the TAMRA Test and therefore be MEC's, most insurers require a disclosure speaking to the ramifications of a Modified Endowment Contract that the policyholder must sign.

Limits But Not Elimination

TEFRA DEFRA and TAMRA rules place limits on life insurance policies that reduce the number of people looking to buy life insurance to shelter funds from taxes.  In truth, the industry has always frowned upon the practice of buying a life insurance policy purely for the purpose of tax sheltering.

This does not, however, eliminate the use of whole life and universal life insurance as an alternative means to accumulate wealth and plan for retirement while reaping the favorable tax benefits life insurance enjoys. 

As long as you know the rules and you agree to live within them, life insurance is a viable option for tax favorable savings.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.

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