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.

22 thoughts on “TEFRA DEFRA TAMRA: How Taxes Effect Life Insurance”

  1. Thank you for an informative ste. As a newer agent in the field I have lots of questions. My question concerns the cash value accumulation test requirements. After a period of time the cash surrender value increases, over time does not the amount at risk decrease? And so my confusion revolves around this. If the cash value is steadly increaseing how can the client possibly pay an increaseing premium to fulfill the requiremen? Obviously the cost of insurance factors into this but I am not understanding how? Rspectfully.

    • Hi Joaquin,

      The CVAT allows for a higher percentage of cash value to death benefit as the insured ages, and this would theoretically callow for an increasing premium.

      At the same time, paid-up additions have a death benefit associated with them, and this is how one would increase his or her premium on the policy, so the net amount at risk may remain constant rather than go down given the increasing death benefit from the paid-up additions.

      Thanks for stopping by.

  2. Dear Mr. Roberts—I have managed a portfolio of UL and VUL policies over many years to maximize the “investment” aspect. After the 15 year anniversary date, I exercised the option to reduce the face for a number of them, which in some cases has resulted in “negative guideline premium.” One carrier appears to be of the view that the negative amount can be amortized (over my actuarial life), while others interpret the “force out” to require return of premium immediately. Since the minimum guaranteed rate on most of these policies is well above current money market rates, amortization would be better for me. There appears, however, to be no uniform rule, and the methodology used by each after a face amount reduction is a “black box”. Is there some a software application you are aware of that has been blessed by the IRS?

  3. Can a failed gpt be managed short of default? If premiums are frozen and you want to reduce DB in latter years what can be done???

    • Hi Frank,
      I’m not sure I understand what you mean by “managed.” If the policy fails GPT, then it’s automatically reclassified and taxes due on gains. It can remain in force. And it can pay a death benefit (taxability of the death benefit changes to a degree).

    • Hey thanks! I’ll bet you’re right about that, and it makes me think we should have a deeper dive resource available on the subject.

  4. Brandon: My wife has an old UL policy issued by Aetna that is now administered by Lincoln Financial. It has a face amount of $50,000, was issued in 1985 and my wife is now age 71. In the past we always paid a pretty much minimal premium and the CV at the end of 2019 was only $2,600. The currently monthly COI is at $90 and we’ve only been paying $200/month into the contract the past several years, since it almost lapsed in 2018. When we recently tried to pay an additional $2,750 they denied $1,100 as exceeding DEFRA. Additionally, they will not accept any future payments this year and will start billing us for $45/month beginning next year. This pretty much assures this policy will lapse in the near future. I’ve written to them for specifics, but never got a definitive answer as to the details of their calculation — they continue to just say it exceeds DEFRA guideline premiums. Any advice on our options, or who we can contact for a review? e.g. insurance commissioner??

    • Hi John,

      There are times when a long time underfunded UL policy can fall into a situation where the premium needed to save the policy from lapse goes beyond the allowable guideline premium. The warning Lincoln is giving you is most likely related to this. The Guideline Premium Test (most likely) used to qualify this policy as life insurance allows for a smaller death benefit relative to cash value as the insured ages, which is advantageous for people who intentionally seek to build up as much cash value as possible in their policies. But it also places smaller limits on allowable premium payments, especially at advanced ages for some circumstances, which you could very well fall into.

      You could always ask Lincoln to confirm the calculation of the guideline premium in this case, to ensure an error hasn’t been made. Beyond that, there may be little you can do to rectify this. It’s certainly unfortunate that no one called your attention to this possibility earlier.

      I don’t see a complaint to the DOI getting you anywhere.

    • Your premium payment does not violate DEFRA limits. They need to accept your premium. Tell them in writing to accept your premium. File a DOI complaint if they don’t.

      There are two reasons why your premium should be accepted. First, the guideline level premium limitation says that the SUM of your premiums cannot exceed the SUM of the guideline level premiums. Any single premium payment can exceed a single guideline level premium as long as your cumulative premiums are less than the cumulative guideline level premiums. Since you’ve been making minimal payments, I highly doubt your cumulative premiums exceed the limit. Ask them for a demonstration that your premium will violate the test.

      Second, IRC Section 7702(f)(6) says you can disregard the guideline premium test if your premium is needed to prevent the policy from terminating.

      If you really do fail the GLP test, then you need to ask the insurer to tell you the exact premium that will keep the policy inforce because the 7702(f)(6) exception requires you to make the smallest possible premium and end the contract year with no cash surrender value. You will have to do this each year.

      Also, just to have fun with them. Tell them you want them to show exactly how they computed the guideline level premium. Your policy was issued before October 21, 1988, and the mortality rules were a little different back then. If they don’t remember that mortality rules changed, then they are going to have an actuary spend a whole day (or two) trying to figure it out.

    • this EXACT thing is happening to me with Lincoln Life. I am very glad you posted this. It’s awful to have paid into this policy since I was 19 years old and they project not accepting premiums when I am 75.

  5. Great article. I have been specializing in max cash accumulation policies and understanding these IRS rules is a must for myself and my clients.

  6. Excellent article. I am preparing for an industry exam. I have to read a very long and technical document on this subject. It was incomprehensible. But now that I read your article, I see the big picture, and the difficult document has become much easier. Thanks.

    • Hey Ryan,

      You’re welcome and thanks for the feedback. Happy we could help make things a bit clearer. Good luck on the exam!

  7. You should have mentioned TRA 1986. It introduced the passive activity loss rules which pretty much wiped out the tax shelter industry, allowing life insurance producers tout life insurance as the last tax shelter — which prompted the creation of the MEC in TAMRA.

  8. Hello,
    My wife has two paid up life insurance policies dated 1988, pre-TAMRA.
    Are there any tax advantages that are grandfathered in because of the date of these policies? I’m interested in possibly overfunding these policies if that is allowed? Any advice would be sincerely appreciated. Thank you.

    • Hi Tim,

      If these are truly paid-up policies it’s unlikely that you’ll be able to put any additional money into them. The mechanism through which you would make these overfunding payments no longer exists.

      If, however, these policies are not technically paid-up and still have the ability to receive payments, her policies should be grandfathered from the Modified Endowment Contract rules so long as you do not make a material change (nor ever made one) to the policy. At this age of the policy, there may not be a huge upside to this fact all on its own as the MEC limitations tend to be more restrictive earlier in the policy’s life. However, a policy this age could have a substantially higher guaranteed rate of accumulation that could be better than the non-guaranteed rates available on a new product–and certainly higher than current market rates. So if you do have the ability to put more money into the policies, you may have an opportunity to benefit from an old interest rate established under very different economic assumptions.

    • First of all, many thanks to Brandon. 🙂

      Hi Tim,

      You may also look into other options that can meet your needs and bring more value and benefits to your family.

      For example, recently I helped a friend to change her Paid-Up Whole Life policy to an Indexed Universal Life policy by using 1035 exchange. She had two options to select from:

      1. She may simply transfer the cash value from the current whole life policy into the new policy without adding any single dollar. The added benefits include: increased face amount/death benefit, the cash value growing with the linked index strategies and guaranteed 0% floor, living benefits including tax-free withdrawal to supplement retirement income and 0%-0.9% net interest rate if taking loan for flexible use (My friend’s previous policy has an 8% interest rate) , added cash indemnity Long Term Care benefits, Extended No Lapse Guarantee Rider (if she wants).

      2. If she still wants to fund more, she can increase the face amount, then all benefits mentioned in the option 1 will also be increased.

      Everyone’s situation is unique. The best way is to examine all aspects of family financial needs and tax planning strategies, and then make a comprehensive and informative decision afterwards.

      I hope this post by no means offends Brandon (I highly respect you and learned a lot from you. I just wanted to share a recent experience or provide any help in case needed. 🙂

  9. Well done podcast!
    I have been involved in the life insurance business since the early 80’s and this was a great history refresher.


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