As we mentioned in previous articles, UL plans are unbundled, the various components of the plan such as insurance charges and earned interest can each be isolated and quantified. Consequently, they are much easier to understand and explain than traditional bundle permanent life insurance products. In this article, we will discuss tax exempt vs non exempt universal life policies.
In order for the Universal life policy to be taxed exempt, it must pass the following tests
1. The exempt test
The Exempt Test is used to determine whether or not a policy is exempt. An exempt policy is one that regards as providing primary insurance protection.The test is a comparison of the accumulating fund values or cash values of the actual policy to the fund or cash values of a standard test policy at each policy anniversary. This Exemption test policy is a hypothetical 20-pay policy with endowment at age 85. On each policy anniversary, the cash value of the actual policy is less than, or equal to, the cash value of the exempt test policy.
An exempt policy can become non-exempt in the future if it fails the exempt test at any anniversary, but fortunately, most insurance companies put contractual provisions in their UL plans that guarantee the insurer will take all necessary steps to make sure that the policy remains exempt.
The consequences for a policy owner when the policy becomes non-exempt can be quite serious. Any gains that have been accumulated in the policy at the time of deemed disposition will be taxable to the policy owner in the year in which this disposition occurs. Income earned in the policy after the deemed disposition will be reported for taxation on an annual accrual basis.
2. Maximum Tax Actuarial Reserve or MTAR
This is the amount the insurer can deduct from the universal life policy for all expenses, such as insurance premium, administration charge .. when they calculate their own corporate income tax. For the UL policy remain exempt
a) Its values can not exceed the MTAR line
b) The face amount or death benefit of the policy can not grow more than 8% each year.
c) The cash value of the policy at the tenth anniversary and each subsequent policy anniversary can not be more than 250% of the cash value of the third preceding anniversary.