Tax Definition of Life Insurance
A comprehensive definition of life insurance was established in 1984 which extends to all 
life insurance contracts issued after December 31, 1984. This is significant, as there had been no statutory definition established prior to this time. Basically, the law states that in order for a contract to qualify as life insurance for tax purposes, it must meet either (1) a cash value accumulation test or (2) a guideline premium and cash value corridor test.
Cash Value Accumulation Test
A policy meets the cash value accumulation test if the cash surrender value does not at any time exceed the net single premium which would have to be paid to fund future benefits.
Target Premium
The minimum amount of premium needed to support both the minimum sum insured (pure insurance) and the cash value is called the target premium. This amount represents the level of funding the insurer recommends to maintain the policy. It is typically based on relatively conservative investment return assumptions and is usually comparable to premiums for a similar whole life policy. Request a FREE Life Insurance Quote
The IRS Corridor
A universal life policy must include an amount at risk. If the cash value approaches the face amount, the death benefit must increase so as to provide for this amount at risk. This minimum separation between the cash value and the death benefit is called the "risk corridor." With the establishment of the Tax Reform Act of 1984, the law now states that the ratio of the death benefit to cash value at any time cannot be less than a specified percent. The face amount of a contract at age 40 or less can never be less than 250 percent of the cash value. This percentage declines steadily each year until age 95.
To maintain this minimum insurance corridor, insurers typically reserve the right to refuse additional premium payments if they would cause the cash value to increase beyond the upper limits relative to the death benefit.
If the policy meets the test, all death benefits from the life insurance contract would qualify for income tax-free treatment. However, if not, both the earnings on the cash value and the proceeds paid to the beneficiary will be taxable (please always consult with yoru accountant for any tax changes and personal situations).
The IRS will get its share of the policy's earnings, but only if and when funds are withdrawn from the policy. There is no tax payable if the policy pays the death benefit. And, because funds are usually withdrawn after the insured retires, the tax rate should be lower than when the insured was working, which is another financial advantage for the insured. Request a FREE Life Insurance Quote
