oversight

Tax Policy: Tax Treatment of Life Insurance and Annuity Accrued Interest

Published by the Government Accountability Office on 1990-01-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

GAO                  Report to t lw Chai man, Comui t t ee OII
                     Finance, U.S. Senate, and the
                     Chairman, Committee on Ways and
                     Means, House of Representatives

January   1990
                     TAXPOLICY
                     Tax Treatment of Life
                     Insurance and Annuity
                     Accrued Interest




GAO/GGD-90-3     1
General Government Division

B-237966
January 29,199O

The Honorable Lloyd Bentsen
Chairman, Committee on Finance
United States Senate
The Honorable Dan Rostenkowski
Chairman, Committee on Ways and Means
House of Representatives

This report is in responseto Section 5014 of the Technical and MiscellaneousRevenueAct of
1988. Section 5014 calls for GAO to report on (1) the effectiveness of the revised tax
treatment of life insurance products in preventing the sale of life insurance primarily for
investment purposes; and (2) the policy justification for, and the practical implications of,
the present treatment of earnings on the cash surrender value of life insurance and annuity
contracts in light of the Tax Reform Act of 1986. There is a recommendation to the Congress
in chapter 4.

As arranged with you, unless you publicly announcethe contents of this report earlier, we
plan no further distribution until 2 days from the date of the report.
Major contributors to this report are listed in appendix II. If you have any questions, please
call me on 275-6407.




Jennie S. Stathis
Director, Tax Policy and
  Administration Issues
Executive Summ~


             The interest that is earned on life insurance policies and deferred annu-
Purpose      ity contracts, commonly referred to as “inside buildup,” is not taxed as
             long as it accumulates within the contract. By choosingnot to tax the
             interest as it is earned, the federal government forgoes an estimated $5
             billion in tax revenue each year.

             In the Technical and Miscellaneous RevenueAct of 1988, Congress
             asked GAO to examine the policy justification for, and practical implica-
             tions of, this tax treatment. Congressalso asked GAO to study how effec-
             tively the revised definition of life insurance contained in the new law
             restricted the sale of investment-oriented life insurance products.


             Inside buildup is not a form of income unique to life insurance or annu-
Background   ity products. It is another name for unrealized or accrued income-
             income earned but not yet received by an investor. Other examples of
             investments with accrued earnings are certificates of deposit, individual
             retirement accounts, 401(k) plans, original issue discount bonds, stocks,
             bonds, and real estate.

             In general, inside buildup earned on life insurance and deferred life
             annuities is not taxed as long as it remains inside the policy. Since the
             buildup grows faster than it would if it were taxed, buyers pay lower
             prices for these products.

             Interest that remains inside a life insurance policy accumulates as long
             as the policy is in force. The amount accumulated benefits the policy-
             holder becauseit helps pay the increasing cost of insurance coverageas
             the policyholder agesand it becomesan increasing part of the policy’s
             death benefit. The inside buildup is not subject to income tax if it is
             received as death benefits by the policy’s beneficiary. Inside buildup is
             taxed if the policyholder surrenders the policy, but not if the policy-
             holder merely borrows the inside buildup.

             Inside buildup accumulates in life annuities only between the time the
             annuity is purchased and the time payments from the annuity begin.
             Unlike life insurance, funds borrowed from an annuity are taxed and a
             penalty tax is imposed. Oncepayments from the annuity begin, the pre-
             viously untaxed inside buildup is paid out over the term of the annuity
             as part of the payment. The inside buildup received with each payment
             is then subject to taxation.




             P8ge 2                                   GAO/GGD4031   Turrtlon   of Indde   Buildup
                            Executive   Summiuy




                            After examining the major arguments for the current tax preference,
Results in Brief            GAO  found only one to have potential merit-without this preference,
                            people may not provide their dependents with adequate insurance pro-
                            tection or themselves with sufficient retirement income. However, GAO
                            believes that inside buildup is accrued income that could be taxed.
                            Accordingly, Congressmay want to reconsider whether the social bene-
                            fits of not taxing the inside buildup are worth the tax revenue forgone.

                            If Congressdecides not to tax inside buildup, GAO believes that amounts
                            borrowed from life insurance inside buildup should be taxed. Since bor-
                            rowing the inside buildup reduces death benefits by the amount bor-
                            rowed, such borrowing is not consistent with the goal of the tax
                            preference, which is to foster insurance protection. In addition, an
                            unlimited right to borrow the inside buildup allows policyholders access
                            to tax-free income and is inconsistent with the tax treatment of borrow-
                            ing from other tax-preferred products, such as annuities. Repayment of
                            previously taxed amounts borrowed should be tax deductible, because
                            repayment restores the death benefit.

                            Congresshas narrowed the tax definition of life insurance, but that defi-
                            nition is likely to remain an issue as long as preferential tax treatment is
                            granted to life insurance products. The 1988 restrictions appear to have
                            reduced substantially the sale of a particular type of investment-ori-
                            ented product-that involving a single premium paid upfront. Whether
                            these restrictions have affected the sale of other investment-oriented
                            life insurance products is more difficult to evaluate.


GAO Analysis

The Inside Buildup Debate   Opponents of taxing inside buildup argue that it is not income and
                            should not be taxed becauseit does not usually generate cash to the
                            owner unless the product is surrendered or liquidated. Instances exist,
                            however, under present law where income is taxed without cash pay-
                            ment. For example, the annualized return on original issue discount
                            bonds is taxed as it accrueseven though no cash may be received until
                            some time in the future. (Seepp. 38 and 39.)

                            Alternatively, there are instances under current law where income is not
                            taxed until cash is realized. For example, accrued capital gains are not
                            taxed, even though they could be considered income. There are two


                            Page 3                                   GAO/CiGDMl   Taxation   of Inside Buildup
                            Executive   Summmy




                            basic arguments for taxing capital gains only when the underlying
                            assetsare sold. First, it would be difficult to value many assetsthat
                            have accrued capital gains, especially if they have not been sold in
                            years. Second,asset prices can fluctuate substantially from year to year.
                            Thus, taxing accrued capital gains could result in the forced sale of an
                            asset to pay the tax.

                            GAO  believes that the payment of cash is not a necessarycondition for
                            income to exist and to be taxed. GAO also believes that the arguments for
                            not taxing accrued capital gains do not apply to inside buildup on life
                            insurance or annuity products. Inside buildup is an amount that can be
                            readily computed, and the tax on it wiII not likely be large enough to
                            force even a partial surrender of the policy. Thus, the arguments for not
                            taxing inside buildup must be based on other factors. (Seep. 39.)

                            GAO  found one argument for not taxing inside buildup to have merit. The
                            argument is that taxing it may reduce the amount of insurance coverage
                            purchased and the amount of income available to retirees and benefi-
                            ciaries. The tax preference on inside buildup is less costly, it is argued,
                            than direct government provision of protection.
                            Adequate coverage for low-income people is largely provided through
                            the Social Security System, which provides both insurance and annuity
                            protection. The tax preference given life insurance and deferred life
                            annuities mainly benefits middle- and high-income people. Empirical
                            studies on the adequacy of life insurance protection are not conclusive.
                            Even if, under the existing tax treatment, the level of protection is ade-
                            quate, GAO has no way to determine if it would remain so if inside
                            buildup were taxed. (Seepp. 41 to 43.)

                            Inside buildup has never been treated as taxable income. However, the
                            tax preference has created incentives to construct products that take
                            advantage of the preference. Accordingly, Congressmay want to period-
                            ically reconsider the policy decision to forgo taxing inside buildup. The
                            central issue, as always, is whether the benefit of the increased protec-
                            tion to the insured’s beneficiaries is worth the tax revenues forgone.
                            (Seepp. 44 to 46.)


Policy Loans Defeat         The purpose of life insurance is to replace income lost as a result of the
Purpose of Life Insurance   death of the insured. Borrowing the accumulated inside buildup of a pol-
                            icy, however, reduces the value of death benefits and, therefore, defeats
                            the purpose of having life insurance. (Seepp. 43 to 44.)


                            Page4                                   GAO/GGDBO41T~tlonofI~ideBuildup
                             J%xecutive Summmy




                             In 1982, Congressdecided to treat borrowing from annuities as taxable
                             and imposed an additional penalty to offset the advantage of accruing
                             interest tax free and only paying tax when funds are withdrawn. In
                             1988, Congresslimited borrowing on certain life insurance policies by
                             narrowing the tax definition of life insurance. One intent underlying
                             both of these tax law changeswas to reduce investor incentives to use
                             borrowing as a source of tax-free income. (Seep. 43.)
                             In keeping with that intent as well as to make the tax treatment of bor-
                             rowing against life insurance more consistent with that of other invest-
                             ment products, borrowing from life insurance should be considered a
                             realization of income and should be taxed. To offset the advantage of
                             accruing tax-free interest income before its withdrawal, a penalty-sim-
                             ilar to that imposed on borrowing from annuities-should be added to
                             the tax. Since repayment of borrowed amounts restores the death bene-
                             fit, any amount that was included in taxable income when borrowed
                             should be deductible when repaid. (Seep. 46.)

                             The staff of the Joint Committee on Taxation has estimated that a tax
                             on borrowing the inside buildup from life insurance policies would raise,
                             on average, over $200 million per year. (Seep. 36.)


Recent Changes in Law        Becauseof concern about the growth of single premium life insurance
Have Affected Product        policies, Congressnarrowed the tax definition of life insurance in The
Cc-l,,                       Technical and MiscellaneousRevenueAct of 1988. Single premium poli-
ixl.1es                      ties, which involve a large initial payment, allow significant and rapid
                             accumulation of inside buildup. The effect of the tax law change has
                             been to reduce the number of single premium policies sold. The effect of
                             this change in the law on other investment-oriented life insurance poli-
                             cies is more difficult to evaluate. (Seepp. 32-33.)

                             Purchasesof deferred annuities fell after borrowing from these prod-
                             ucts was taxed. Growth has since resumed and, in fact, increased after
                             the Tax Reform Act of 1986 put limits on competitive tax-preferred
                             products, such as Individual Retirement Accounts. (Seepp. 36-37.)

                        A-

Recommendation               The type of products offered as well as who buys those products can
                             change. As a result, Congressmay want to reconsider periodically its
                             policy decision to grant preferential tax treatment to inside buildup,
                             weighing the social benefits against the revenue forgone.



                             Page 5                                  GA0/GGD!30-31   Taxation   of Inside Buildup
           Executive   Summary




           If Congressdecidesnot to tax inside buildup, then GAO recommendsthat
           Congresseliminate tax-free borrowing of life insurance proceeds.Any
           borrowing of these proceedsshould be considered a distribution of inter-
           est income. To offset the advantages of accruing interest income without
           tax, a penalty provision needsto be added. Since repayment of the
           amount borrowed restores the death benefit, any amount that is taxed
           when it is borrowed should be tax deductible if subsequently repaid.


                 obtained oral comments from industry representatives on this
Comments   GAO
           report. According to them, the current tax treatment of inside buildup is
           justified. They believe that recent changesin the tax laws have elimi-
           nated serious abuses.In their view, loans are a legitimate part of the life
           insurance product and are generally used to serve important social
           goals, such as financing a home or paying tuition.




           Page 6                                   GAO/GGDgo31   Taxation   of bide   Buildup
Page 7   GAO/GGD90-31   Taxation   of hide   Buildup
Contents


Executive Summary                                                                                      2

Chapter 1                                                                                         10
Introduction          Objectives, Scope,and Methodology                                           11

Chapter 2                                                                                         13
What Is Inside        Life Insurance and Inside Buildup                                           13
                      Life Annuities and Inside Buildup                                           18
Buildup?
Chapter 3                                                                                         22
Favorable Tax         Life Insurance and-Annuity Inside Buildup Are Taxed the                     23
                           Same Inside but Differently OnceOutside of the
Treatment of Inside        Product
Buildup Encourages    Comparison of Tax Treatment of Life Insurance and                           28
Investment-Oriented        Deferred Annuities With Other Investments
                      Implications of Tax Preferenceson Life Insurance and                        31
Products                   Annuity Products

Chapter 4                                                                                         38
The Inside Buildup    Inside Buildup Is Income                                                    38
                      Tax Preference May Encourage Saving Through Life                            39
Debate                     Insurance Companies but Has Little Effect on Total
                           Saving
                      Tax Preference IncreasesLong-Term Capital Formation                         40
                           Financed by the Insurance Sector but Not for the
                           Entire Economy
                      Insufficient Provision for Beneficiaries’ Future Needs                      41
                           Provides Primary Support for Tax Preference
                      Policy Loans Defeat Purpose of Life Insurance and Should                    43
                           Be Taxed
                      Conclusions                                                                 44
                      Recommendation                                                              46
                      Comments                                                                    46

Appendixes            Appendix I: Calculation of ExcessPremiums on Whole                          48
                         Life Insurance
                      Appendix II: Major Contributors to This Report                              49




                      Page 8                               GAO/GGDWl    Taxation   of bide   Buildup
Tables   Table 2.1: Annual Premiums on $100,000 Life Insurance                         16
             Policies
         Table 2.2: ExcessPremiums, Inside Buildup, Cash Value,                        17
             and Actual Insurance Coveragefor a $100,000
             Annual Premium Whole Life Policy
         Table 2.3: ExcessPremiums, Inside Buildup, Cash Value,                        17
             and Actual Insurance Coverage for a $100,000 Single
             Premium Whole Life Policy
         Table 2.4: Premiums on a $10,000 Life Annuity Beginning                       20
             at Age 60
         Table 3.1: Premiums for $100,000 Whole Life Insurance                         24
             Policies When Inside Buildup Is Taxed and Not Taxed
         Table 3.2: Premiums for Deferred Annuity of $10,000                           24
             Annually When Inside Buildup Is Taxed and Not
             Taxed
         Table 3.3: Taxable Income, After Annuitization, on a                          25
             $10,000 Annualized Deferred Annuity Computed
             Under IRS Formula and Actuarially
         Table 3.4: Taxation of Instruments With Accrued Gains                         30
         Table 3.5: Premiums Earned on Single Premium and Other                        33
             Ordinary Life Insurance
         Table 3.6: Salesof Individual Annuities                                       37
         Table I. 1: Calculation of Yearly and Cumulative Excess                       48
             Premiums on a $100,000 Annual Premium Whole Life
             Policy

Figure   Figure 2.1: Cumulative Inside Buildup Earned on a
             $10,000 Deferred Life Annuity




         Abbreviations

                   American Council of Life Insurance
                   Certificates of Deposit
                   first in, first out
                   Individual Retirement Accounts
                   Internal RevenueService
                   last in, first out
                   Life Insurance and .Marketing ResearchAssociation


         Page 9                                GAO/GGDWl     Taxation   of Inside Buildup
Chapter 1

Introduction


               Certain life insurance and annuity products have historically been
               granted preferential treatment under the Internal RevenueCode. During
               the 198Os,many of these same products and the methods of marketing
               them changed significantly. Concerned about the potential for misuse of
               the preferential tax treatment, Congresshas placed limits on these prod-
               ucts by narrowing the definition of life insurance and by penalizing bor-
               rowing against annuities.

               Whole life insurance policies are usually paid for with annual premiums
               spread over the life of the insured or over a specified number of years.
               In the early years of the policy, the premiums more than cover the cost
               of insurance. The excessis invested to provide for later years when the
               cost of insurance rises. Deferred life annuities pay benefits after a speci-
               fied time has elapsed. They may be paid for with either a single pre-
               mium or with a series of premiums that stop before or at the end of the
               period of deferral.
               Both whole life insurance and deferred annuities offer forms of protec-
               tion to the purchaser, but they are also used for savings. The basic tax
               advantage common to both is that the interest earned on the savings
               element is not taxed as it accumulates. For life insurance, the savings
               element plus interest earned is used in later years to supplement pre-
               mium payments when mortality costs are higher and to pay a part of the
               promised death benefits. If the insured dies, the interest accumulation is
               paid to the beneficiary and is not subject to income tax. If the insured
               surrenders the policy, the interest accumulation will be subject to tax as
               long as the cash value plus the sum of dividends previously paid out to
               the policyholder is greater than the sum of premiums paid by the policy-
               holder. No tax is levied on borrowing the inside buildup. For annuities,
               the savings plus interest earned pay a part of the annuity benefits. No
               tax is levied on accumulated interest until the annuity benefits are actu-
               ally paid out. However, any amount borrowed or withdrawn during the
               period of deferral is taxable. Becausethe interest is not taxed as it is
               earned, both the surrender of life insurance policies and the cashing in
               of deferred annuities involve postponement of tax.

               The exclusion from taxation of most interest income earned on life
               insurance and annuity contracts is estimated to cost the federal govem-
               ment over $5 billion a year, according to the Joint Committee on Taxa-
               tion. If just the interest income on new life insurance policies were
               taxed, revenue would reach about $900 million a year in 5 years, accord-
               ing to the Congressional Budget Office.



               Page 10                                  GAO/GGD9041   Taxation   of Inside Buildup
                         chapter 1
                         Introduction




                         In the Tax Equity and Fiscal Responsibility Act of 1982, Congress
                         decided to treat borrowing from deferred annuities as a taxable distribu-
                         tion. Except for a limited set of circumstances, an additional penalty tax
                         was imposed on the amount borrowed to offset the benefits policyhold-
                         ers gained from tax deferral. Concernedabout an increasing number of
                         investment-oriented life insurance products, Congress,for the first time,
                         explicitly defined a life insurance policy for tax purposes in the Deficit
                         Reduction Act of 1984. With a rapid increase in the sale of single pre-
                         mium life insurance products, Congressfurther narrowed the tax defini-
                         tion of life insurance in the Technical and MiscellaneousRevenueAct of
                          1988. To be considered life insurance for tax purposes, a policy must
                         involve at least seven annual premiums. A policy with fewer than seven
                         annual premiums is called a “modified endowment policy” and has very
                         restrictive borrowing privileges, much like those of annuities.


                         The Technical and Miscellaneous RevenueAct of 1988 directed that we
Objectives, Scope, and   examine the policy justification for the current tax treatment of inside
Methodology              buildup in life insurance and annuity products, as well as analyze the
                         practical implications of that treatment. In addition, we were to study
                         how effectively the law’s revised definition of life insurance prevented
                         the sale of life insurance products primarily for investment purposes.

                         To examine the justification for, and policy implications of, the current
                         tax treatment, we examined accounting, actuarial, economic, and insur-
                         ancejournals and periodicals. In addition, we studied statements and
                         testimony of industry representatives and economic, legal, and insur-
                         ance experts. From our literature search, we extracted what we believe
                         to be the primary arguments for and against the current tax treatment
                         of inside buildup. Chapter 4 discussesthese arguments and evaluates
                         their strengths and weaknesses.

                         We examined trends in the industry to determine the policy implications
                         of the tax treatment of inside buildup and the effects of the new defini-
                         tion of life insurance. Our primary sourcesof data used to examine
                         these trends were the 1988 Life Insurance Fact Rook and the 1989 Life
                         Insurance Fact Book Update, both of which were published by the
                         American Council of Life Insurance; and various reports and pamphlets
                         published by the Life Insurance and Marketing ResearchAssociation,
                         Inc. (LIMRA). To gain a fuller understanding of the products that are
                         available and their relative importance, as well as to discussthe most
                         recent trends in the industry, we visited the offices of LIMRA and inter-
                         viewed LIMRA officials.


                         Page 11                                 GAO/GGD90-31   Taxation   of Inside Buildup
chapter 1
Introduction




We received informal oral comments from representatives of the life
insurance industry. Since they believe the current tax treatment is
proper, they disagreed with our position. Our work was done between
April and September 1989, primarily in Washington D.C. and in accord-
ance with generally acceptedgovernment auditing standards.




                             .



 Page 12                              GAO/GGD!W21   Taxation   of Inside Buildup
What Is Inside Buildup?


                     The interest that accumulated on life insurance policies and deferred
                     annuities was an estimated $45 billion in 1986. Each year policyholders
                     and future annuitants accumulate an amount of this magnitude on a tax-
                     free or tax-deferred basis. In deciding whether inside buildup is to
                     remain tax-preferred or to be considered a source of tax revenue, it is
                     necessaryto understand what it is and the purpose it serves.

                     ‘Inside buildup” refers to the growth of interest income within life
                     insurance policies and deferred annuities. Inside buildup is not a unique
                     form of income: it is simply another name for unrealized income or
                     gains- income that has been earned but not received by an investor.
                     Unrealized income or gains occur with many kinds of investments.
                     These investments include certificates of deposit (CDS);individual retire-
                     ment arrangements (IRAS);401(k) plans; original issue discount bonds,
                     such as zero coupon bonds; stocks and bonds (capital gains); and real
                     estate. For instance, CDSearn interest income as they are maturing, but
                     investors have the option of not receiving the income until the CD has
                     matured. Stocks and bonds, even though they pay a periodic income as
                     dividends or coupon interest, may appreciate in value. This appreciation
                     or capital gain is earned by investors but is not received until the stock
                     or bond is sold.


Life Insurance and   Life insurance enables individuals to reduce the risk of financial loss to
                     their families or other parties in the event of the policyholder’s death.
Inside Buildup       Risks are reduced by pooling the risks (i.e., the probability of death) of
                     many individuals. If the risks are small, the cost to each individual will
                     also be small. For example, if 10,000 people wished to provide $10,000
                     to their families if they died in the next year, and the insurance com-
                     pany estimated that only 10 of the 10,000 people would die during the
                     year, the cost of the insurance would be $10 per person ($100,000 bene-
                     fits paid / 10,000 policyholders = $10 per policyholder). However, if the
                     insurance company estimated that 5,000 people would die, the cost
                     would jump to $5,000 per person1

                     This example illustrates the fundamental nature of life insurance: as the
                     probability of death increasesthe cost of insurance also increases.While
                     the nature of insurance remains the same,the industry has developed a
                     multitude of insurance products, such as universal life and variable life

                     ‘This example disregards what are called “loading charges.” These costs are included in life insur-
                     ance premiums so that insurance companies can cover their casts of doing business.



                     Page 13                                                GAO/GGD90-31       Taxation   of Inside Buildup
                       chapter 2
                       What Ia Inside Buildup?




                       insurance, to meet the varied needsof people. However, all the policies
                       offered are essentially variations on the two basic types of insurance:
                       term (temporary) insurance and whole life (permanent) insurance.


Term Insurance         Term insurance pays the beneficiary of a policy the promised death ben-
                       efits if the insured dies within a certain period of time (usually 1 year).
                       A l-year term policy involves almost no savings; it is often termed
                       “pure” insurance.

                       The premium for a given amount of term insurance increaseswith the
                       age of the insured becausethe insured’s probability of death increases.
                       With a greater number of people dying each year as a given group of
                       people grows older, insurance companies must charge higher and higher
                       premiums to cover the promised death benefits. Thus, a given amount of
                       term insurance that costs people hundreds of dollars a year when they
                       are in their 20s may cost them thousands of dollars a year when they
                       are in their 60s. For example, a $100,000 l-year term policy that costs a
                       person $169 at age 25 would cost $2,421 by age 65. If a person age 25
                       lived to age 99 and purchased a $100,000 l-year term policy each year,
                       total premiums paid over the years would equal $636,187.”

                       The increasing cost of term insurance is a major drawback in holding
                       this type of insurance. As people age,their incomes may not increase as
                       fast as the insurance premiums. The premiums may take a larger and
                       larger portion of their income over time. This problem is solved with
                       whole life (permanent) insurance.


Whole Life Insurance   Under a whole life insurance policy, coverageof $100,000 a year from
                       age 25 to 99 could be purchased for 75 annual premiums of $676, or a
                       total of $50,700. Whole life insurance pays the beneficiary of a policy
                       the promised death benefits (face value of the policy) whenever the
                       insured dies. It does this through a combination of decreasingterm
                       insurance and increasing accumulated savings. The sum of these always
                       equals the face value of the policy.



                       ‘The premiums,    which do not include loading costs, are calculated using the 1980 Commissioners’
                       Standard Ordinary Mortality Table for males, with an interest rate of 5 percent. This example, and
                       othen throughout the report, are not intended to represent actual policies sold by the insurance
                       industry. They are used only to describe the relationship between premiums, cash values, and death
                       benefits for various kinds of policies.    ;



                       Page 14                                               GAO/GGDBOCSl     Taxation   of Inside Buildup
chapter 2
What LB Inside Buildup?




The premiums for whole life may be spread over the life of the insured.
However, unlike term insurance, whole life premiums do not increase
with the age of the insured. The “excess” premiums are invested by
insurance companies and earn interest income for policyholders. For
whole life premiums to pay the increasing cost of mortality (the increas-
ing costs of term insurance as the insured ages),they must be greater
than the premiums for term insurance in the early years of the policy.

The difference between the whole life premiums and the cost of the
actual term insurance provided in the early years of a policy represents
the savings element of life insurance. The “excess” premiums are
invested by insurance companies and earn interest income for policy-
holders. The accumulation of interest income in an insurance policy is
the inside buildup.

The sum of the accumulated excesspremiums and interest income
equals the cash value of a policy. The cash value of a whole life policy is
available to policyholders during their lives through surrender of the
policy or through borrowing. As the cash value of a policy grows, the
amount of actual insurance coveragethat needsto be provided to main-
tain the face value or death benefits of a policy decreases.However, the
cash value plus the actual insurance coveragealways equals the face
value of a policy.

As the insured ages,the cost of insurance coveragebegins to exceedthe
annual premiums. At this time, the accumulated excesspremiums and
inside buildup (accumulated interest income) are used to supplement the
annual premiums. In effect, interest income earned for policyholders by
the insurance company is used so that policyholders may pay the
increasing cost of their insurance coverageand, as will be shown, is used
to supplement the decreasinglevel of actual insurance protection pro-
vided by the company.

The savings aspect of whole life insurance may be increased by paying
larger and fewer premiums early in the policy. If premiums are paid
early, inside buildup accumulates in greater amounts. For instance, it
was common to pay premiums for whole life insurance over 20 years
instead of over the life of the insured. At the end of 20 years, the inside
buildup and accumulated excesspremiums were sufficient to pay the
costs of insurance coveragefor the rest of the insured’s life. The savings
element of whole life is taken to the extreme when it is paid for with a
single premium; such a policy provides the greatest accumulation of
                              .


Page 16                                 GAO/GGIMO31   Taxation   of Inside Buildup
                                         b-2
                                         what   t lndde   Buildup?




                                         interest income. Another type of policy, universal life, allows policy-
                                         holders to vary, within certain limits, the amount of death benefits and
                                         the timing and amount of premiums. This policy allows them to deter-
                                         mine how much of their premiums is saved and how the interest income
                                         is used.

                                         One incentive to purchase whole life rather than term insurance is that,
                                         unlike comparable investments, interest income built up within the pol-
                                         icy is not taxed as it is earned. This incentive will vary depending on
                                         how interest rates paid on the savings aspect of life insurance compare
                                         with the rates offered on other taxable investments.


Inside Buildup Illustrated               Table 2.1 shows the annual premiums for l-year term, annual premium,
                                         and single premium life insurance for a $100,000 policy purchased
                                         beginning at age 25. For about the first 25 years, the premiums on l-
                                         year term insurance are lower than those on annual premium whole life.
                                         The difference between the two policies is approximately equal to the
                                         excesspremiums that are saved and invested for the whole life policy-
                                         holder.3For the single premium policy, virtually the entire premium is
                                         saved and invested. The premium plus inside buildup on a single pre-
                                         mium policy is enough to pay the cost of actual insurance coverageover
                                         the life of the insured.
Table 2.1: Annual Premiums on $100,000
Life Insurance Policies                                                                            Type ot Policy
                                                                           1-Year                       Annual                            Single
                                         AIP                                 term                     premium                          premium
                                         25                                  $169                           $676                         $12,432
                                         35                                   201                            676                                   .
                                         45                                   433                            676                                   .
                                         55                                   997                            676                                   .
                                         65                                 2,421                            676                                   .
                                         75                                 6.113                            676                                   .

                                         Note: Premiums were computed ustng the 1980 Commissioners’ Standard Ordinary Mortality Table for
                                         males and an interest rate of 5 percent. The premiums do not Include loading costs.




                                         ?he difference ia only approximate because under the l-year term policy the insurance coverage
                                         stays at d 100,000 while under the whole life policy the lnsursnce coverage, not the face value of the
                                         policy, decreases as the policyholder ages and the cash value builds up. The cost of insurance cover-
                                         age under a whole life policy is therefore less than under the l-year term policy.



                                         Page 16                                                 GAO/GGDBMl         Taxation   of Inside Buildup
                                     chapter 2
                                     What h lnaide Buildup?




                                     As the cash value (excesspremiums and interest income) builds up
                                     within a whole life policy, the amount of actual insurance coveragepro-
                                     vided decreases.If a person reachesthe maximum age in a mortality
                                     table, the actual insurance coverage for the last year is zero. The death
                                     benefits are then totally provided for out of the inside buildup. Tables
                                     2.2 and 2.3, based on the premiums used in table 2.1, show the relation-
                                     ships between the excesspremiums, inside buildup, cash value, and
                                     actual insurance coveragefor the whole life and single premium poli-
                                     cies.4For l-year term insurance there are no excesspremiums, inside
                                     buildup, or cash value.
Table 2.2: Excess Premiums, inside
Buildup, Cash Value, and Actual                          Cumulative                                           Actual
Insurance Covemge for a $loO,OCM                             excess            Inside                     insurance
Annual Premium Whole Life Policy     Aae                  Premiums            builduo      Cash value      covemae        Face value
                                     25                          $508              $26             $534      $99,466         $100.000
                                     35                         5.609            2,010            7,619        92,381         100,000
                                     45                         9,699            8,207           17,905        82,095         100,000
                                     55                        11,326           20,165           31,906        68,509         100,000
                                     65                         8.335           39.321           47.656        52344          100,000
                                     75                         (2,169)         66,410           64,241        35,759         100,000
                                     85                       (22,936)         100,693           77,757        22,243         100,000
                                     95                       (51,258)         140,540           89,283        10,717         100,000
                                     99                       E8.557)          158.557          100.000             0         100.000


Table 2.3: Excess Premiums, Inside
Buildup, Cash Value, and Actual                          Cumulative                                           Actual
Insurance Coverage for a $1 W,ooO                            excess            Inside                     insurance
Single Premium Whole Life Policy     Aae                  premiums            buildup      Cash value      coveraae       Face value
                                     25                       $12,285             $614         $12,899       $87,101         $100,000
                                     35                        10,832            8,271          19,103        80,897          100,000
                                     45                         8,493           19,618          28,111        71,889           100,000
                                     55                         3.998           36.010          40.008        59.992           100.000
                                     65                         (4.541)         581704          54.163        45.837           100,000
                                     75                       (19,659)          88,346          68,687        31,313           100,000
                                     85                       (43,764)         124,287          80,523        19,477           100,000
                                     95                       (74,484)         165,099          90,615         9,385           100,000
                                     99                       au.2441          183.244         100.000             0           100.000


                                     The cash value (excesspremiums plus inside buildup) plus actual insur-
                                     ance coverage equals the face value of the policy, $100,000. The excess

                                     4The calculation of excess premiums is presented in appendix I.



                                     Page 17                                               GAO/GGD90-21   Taxation   of Inside Buildup
                     chapter 2
                     What b Inside Buildup?




                     premiums in the early years are positive when they are saved and earn
                     interest income. By ages65 and 75 in these examples, the excesspremi-
                     ums becomenegative; at this time, the inside buildup begins to supple-
                     ment the annual premium to pay the cost of the actual insurance
                     coverage. For the single premium policy, the inside buildup pays the
                     entire cost of the actual insurance coverage.The remainder of the inside
                     buildup supplements the actual insurance coverage so that the value of
                     the death benefits remains constant. By age 99, the highest age used in
                     the mortality table, the inside buildup has grown to equal the death ben-
                     efits; the actual insurance coverage at this age is zero.

                     As can be seen from tables 2.2 and 2.3, the inside buildup on the single
                     premium policy for each year is greater than that for the annual pre-
                     mium policy, becausethe excesspremiums invested in the policy in the
                     beginning are much greater in the single premium policy.

                     In summary, inside buildup on life insurance is unrealized income to pol-
                     icyholders, income that is used to help pay the increasing costs of their
                     actual insurance and to pay an increasing p&t of their death benefits. It
                     is income that, when realized, may never be taxed.5

                     Life annuities are, in a sense,the opposite of life insurance. While life
Life Annuities and   insurance pays a benefit when the insured dies, life annuities pay bene-
Inside Buildup       fits (usuaIIy annually or monthly) as long as the insured lives or for a
                     specified period of time if living. Life annuities are used as a source of
                     retirement income. For instance, people may invest their IRA savings in
                     life annuities and begin drawing benefits when they retire.

                     Life annuities may be either immediate or deferred. An immediate annu-
                     ity is purchased with a single premium and begins to pay benefits right
                     away. The premium is invested and earns interest income. The interest
                     income, along with a part of the premium, is paid out as it is earned, and
                     thus constitutes the annuity’s benefits. When the insured dies, any pre-
                     mium remaining helps pay the benefits of other annuitants. These
                     amounts are called “survivorship benefits.” Becausethe interest income
                     under an immediate annuity is paid out as it is earned, no inside buildup
                     accrues in such a policy.




                     ‘See chap. 3 for a discussion of the tax treatment of inside buildup.



                     Page 18                                                  GAO/GGB904     Taxation   of Inside Buildup
                             chapter 2
                             What b Innide Bufldop?




                             Deferred life annuities pay benefits after a specified time has elapsedor
                             a certain age is attained. They may be paid for with either a single pre-
                             mium or with a series of premiums that stop before or at the end of the
                             period of deferment. Like immediate annuities, deferred annuities earn
                             interest income; unlike immediate annuities, the interest income earned
                             builds up within the policy during the period of deferment and is availa-
                             ble to pay annuity benefits. As with life insurance, the sooner the premi-
                             ums are paid, the greater the amount of inside buildup.

                             If the interest rates offered on life annuities are competitive, one reason
                             for buying a deferred life annuity now rather than an immediate life
                             annuity later is that the inside buildup accumulated during the period of
                             deferment is not taxed as it is earned. The same annuity may therefore
                             be purchased with a smaller after-tax premium, measured in present
                             value terms. For example, a $10,000 immediate annuity may be pur-
                             chased for a $116,855 premium at age 60. If the insurance company
                             guarantees an interest rate of 6 percent, the same annuity may be pur-
                             chased for a $13,403 premium at age 25. However, if people wanted to
                             save the money themselves to pay the premium at age 60, they would
                             have to invest $26,594 at age 25, assuming a 6-percent return in a tax-
                             able investment. Their cost would be almost 100 percent greater.”


Inside Buildup Illustrated   In the same manner as permanent life insurance, inside buildup is
                             earned but not realized on deferred life annuities. Onceannuity benefits
                             begin, however, interest income stops building up within the annuity.
                             When part of the accumulated interest income is included in the annuity
                             benefits, the inside buildup paid out is realized as income.

                             The inside buildup on deferred life annuities plus the premiums paid
                             (plus survivor-ship benefits) must equal the single premium on an imme-
                             diate life annuity of the same amount. This equality can be seenby con-
                             sidering the premiums and inside buildup on representative immediate,
                             deferred, and single premium deferred life annuities.

                             The premiums on a $10,000 life annuity beginning at age 60 and ending
                             at the death of the annuitant are presented in table 2.4. The premium at
                             age 60 is $116,855. The same annuity may be purchased at age 25 for 35
                             annual premiums of only $886 for a total of $21,020; it may also be
                             purchased for a single premium of $13,403 at age 25. Since the reserves

                             6There are taxdeferred alternatives to purchasing a deferred annuity. For instance, people may save
                             through IRAs and buy an immediate annuity when they retire.




                             Page 19                                               GAO/GGD99-31     Taxation   of Inside Buildup
                                        chapter 2
                                        What Ls Inside Buildup?




                                        (the amount of funds in a policyholder’s account) on both deferred
                                        annuities must equal $116,885 by age 60 if they are to pay the same
                                        benefits, the differences between the premiums are made up with inside
                                        buildup (plus survivorship benefits).
Table 2.4: Premiums on a $10,000 Life
Annuity Beginning at Age 60                                                                    Type of annuity
                                                                                                      Annual                                Single
                                                                                                    premium                              premium
                                        Age                         Immediate                       deferred                             deferred
                                        25                                        .                        $886                           $13.403
                                        30                                        .                         886                                  .
                                        35                                        .                         886                                  .
                                        40                                        .                         886                                  .
                                        45                                        .                         886                                  .
                                                                                                                                                -
                                        50                                        .                         886                                  .
                                        55                                                                  886                                  .
                                        60                             $116.85;                                .                                 .

                                        Note: Premiums were computed using the 1971 Male Annuity Mortaltty Table with an Interest rate of 6
                                        percent The premiums do not include loading costs


                                        Figure 2.1 shows the cumulative inside buildup on the annual premium
                                        and single premium deferred annuities. The amount of inside buildup on
                                        the ‘annual premium deferred annuity is about $78,000 at age 60. This
                                        interest income plus the premiums paid, $31,010 ($886 x 35) almost
                                        equals the cost of the immediate annuity.’

                                        The single premium deferred annuity earns a greater inside buildup. By
                                        age 60, when the annuity begins, the inside buildup totals about
                                        $95,000. This buildup is almost 22 percent more than under the annual
                                        premium deferred annuity. In both cases,the inside buildup accumu-
                                        lates tax-free, to the benefit of the policyholder. Only when the annuity
                                        begins is the inside buildup taxed.8




                                        7The difference is made up from the reserves (premiums, interest income, and survivorship benefits)
                                        of those annuitanta who died during the period of deferment. Those reserves are allocated to the
                                        accounts of the living.

                                        ‘See chap. 3 for a discussion of the tax treatment of inside buildup on deferred annuities



                                        Page 20                                                 GAO/GGIMO-31       Taxation   of hside     Buildup
                                        chapter 2
                                        What la lnaide Buildup?




Figure 2.1: Cumulative Inside Buildup
Earned on a $10,000 Deferred Life
Annuitv                                 100   Thousands of Ddlan




                                              30        35         40         45   so   56      so

                                                      Annual Premium Policy
                                                      Single Premium Policy




                                                                                                                                     .
                                        Page 2 1                                        GAO/GGD9041   Taxation   of Inside Buildup
Favorable Tax Treament of Inside Buildup
Encourages Investment-Oriented Products

               The inside buildup on life insurance and deferred annuities is treated
               similarly under current tax law as long as the funds remain in the prod-
               uct. However, tax law treats funds that are withdrawn or borrowed
               from a life insurance policy more favorably than funds withdrawn or
               borrowed from an annuity.

               Tax treatment of investments does not always resemble that of life
               insurance and annuities. The tax treatment of interest accumulating in
               whole life insurance and deferred annuities resemblesthe tax treatment
               of interest accumulating on other forms of deferred compensation, such
               as individual retirement accounts. There are, however, important differ-
               ences.Unlike these other deferred compensation products, there are no
               legal limits on how much can be invested in life insurance and annuity
               products. In addition, no tax consequencesresult from borrowing from a
               life insurance policy. The only borrowing limit is the cash value of the
               policy. The tax treatment of life insurance products closely parallels the
               tax treatment of capital gains income. However, it is not clear that
               inside buildup and accrued capital gains have as much in common as
               their respective tax treatments would indicate.

               The tax preference granted to inside buildup increased the variety of
               investment-oriented life insurance products and the amounts invested in
               those products. Someof these products have led to concernsthat the tax
               preference generates products that are geared more to investment pur-
               posesthan to life insurance purposes. There are different ways of allevi-
               ating those concerns.Changing the definition of life insurance is one of
               those ways.

               To restrict the ability of investors to put large amounts of money in poli-
               cies that were more oriented toward generating tax-preferred invest-
               ment returns (inside buildup) and less oriented toward life insurance
               protection, Congressdefined life insurance for tax purposes in the Defi-
               cit Reduction Act of 1984. Becauseof the rapid increase in the salesof
               single premium life insurance policies in the mid-1980s, Congressnar-
               rowed the definition further in the Technical and MiscellaneousRevenue
               Act of 1988.1The sales of a specific product, the single premium policy,
               appear to have fallen as a result of this 1988 tax law. However, it is
               more difficult to evaluate how these changesin definition have affected
               the sale of investment-oriented life insurance policies in general.


               ‘These policies allowed for a large and rapid accumulation of inside buildup. in addition. they often
               provided very liberal loan provisions For a more detailed discussion, see Tax Policy: Taxation of
               Single Premium Life Insurance (GAO/GQD-88-SBR), October 16,1987.



               Page 22                                                 GAO/GGDWl         Taxation   of Inside Buildup
                                  clupter  3
                                  Favomble Tax Treatment of Inside wlildap
                                  EncouragesI.nveatme nt43rient.d Pnnhcta




                                  More direct approaches exist to achieve the goals of reducing the invest-
                                  ment-orientation of life insurance and of keeping policyholders from
                                  gaining easy accessto tax-preferred funds. If the concern is that inves-
                                  tors have the ability to shelter large amounts of income from tax, a tax
                                  on inside buildup or limits on the amount of life insurance that is
                                  granted tax-preferred status might more effectively deal with that con-
                                  cern. If the concern is the ready accessto tax-preferred funds through
                                  borrowing, then limiting or taxing borrowing may be a better approach
                                  than altering the definition of life insurance.


                                  As funds remain inside a life insurance or deferred annuity product,
Life Insurance and                they generate interest that is credited to the product’s owner. If these
Annuity Inside                    funds remain in the policy or annuity, the interest accumulation is not
Buildup Are Taxed the             taxed. Oncethe funds are realized (i.e., taken out of the policy or annu-
                                  ity), the tax treatment accorded annuities differs greatly from that of
Same Inside but                   life insurance. Inside buildup on a life insurance policy may be realized
Differently Once                  by the policyholder or beneficiary through (1) death benefits, (2) policy
                                  loans, (3) surrender of the policy, or (4) policy dividends. For annuities,
Outside of the Product            inside buildup can be realized through (1) liquidation-when payment
                                  of funds into the annuity stops and payment of funds out of the annuity
                                  begins-, (2) loans against the annuity, (3) cashing in the annuity-if
                                  this is allowed-, or (4) policy dividends. In the following sections, we
                                  will describe how each of these forms of realization are taxed under cur-
                                  rent law.


Unrealized Inside Buildup  The inside buildup and, in sometypes of policies, the policyholder divi-
Not Taxed for Annuities or dends  generated by funds on deposit in a life insurance policy accumu-
                           late without current taxation.2 As a result, the inside buildup grows
Life Insurance             faster than it would if it were subject to current taxation. The faster the
                                   buildup of interest inside a policy, the lower the premiums insurance
                                   companies will charge for the same coverage.Table 3.1 shows the dif-
                                   ference in premiums on a $100,000 whole life policy under the current
                                   tax treatment-that is, with no tax on inside buildup and with a hypo-
                                   thetical tax of 28 percent on the interest accumulation. Lower premiums
                                   obviously benefit both insurance companies and their policyholders.




                                   ‘In certain situations, a current tax is generated by the accumulation of policyholder dividends 111a
                                   policy. See the section on policyholder dividends.



                                   Page 23                                                 GAO/GGEMO41       Taxation   of Inside Buildup
                                           Chapter 3
                                           Favorable Tax Treatment of Inside Buildup
                                           Encourages Investment4Mented     Products




Table 3.1: Premiums for $100,000 Whole
Life Insurance Policies When Inside                                                                          Premiums
Buildup Is Taxed and Not Taxed                                                      Inside buildup not                           If buildup     were
                                           Type of policy                                         taxed                      -                 taxed
                                           Annual premium                                    $676/year                                  $909/year
                                           Single premium                                       $12,432                                    $20 742
                                           Note Premiums based on a poky purchased by a 25.year-old male usmg 1980 Commlssloners Sland
                                           ard Ordmary Mortality Table for males with an Interest rate of 5 percent and a marginal tax rare of 28
                                           percent Premiums do not Include loadmg costs


                                           From the insurance companies’ standpoint, lower premiums mean they
                                           can sell more policies or more insurance per policy. Lower premiums are
                                           possible becausethe inside buildup grows at a faster rate when not
                                           taxed and can eventually pay a greater portion of the promised death
                                           benefits. From the policyholders’ standpoint, the amount paid for a
                                           given amount of insurance is lower and the amount invested in the pol-
                                           icy (i.e., the unused premiums) earns interest income at a higher rate
                                           than if it were taxed. The cash value of the policy (unused premiums
                                           plus accumulated interest income) is available to policyholders through
                                           borrowing or upon surrender of the policy in whole or in part. i

                                           Inside buildup on deferred annuities is given the same tax treatment
                                           accorded unrealized interest income earned on life insurance. -4spremi-
                                           ums’are paid into a deferred annuity but before any amount is actually
                                           received by the annuitant, the interest income earned accumulates with-
                                           out any current tax. The owner’s wealth increaseswith the interest
                                           accumulation and at a faster rate than if the interest accumulation were
                                           subject to current taxation. Table 3.2 shows the difference in premiums
                                           on a $10,000 deferred annuity with no tax and with a hypothetical tax
                                           of 28 percent on the inside buildup. From the standpoint of the annuity
                                           owner, fewer resourcesor out-of-pocket costs are neededto provide
                                           income for retirement, for example, or for any other purpose.
Table 3.2: Premiums for Deferred Annuity
of $10,000 Annually When Inside Buildup                                                                      Premiums
lo Taxed and Not Taxed                                                              Inside buildup not                            If buildup    were
                                           Type of policy                                        taxed                                         taxed
                                           Annual premtum                                      $886/year                               $1,48O/year
                                           Single premium                                        $13,403                                      $27.064
                                           Note: Premiums based on a deferred annuity purchased by a 25.year-old male to begin at age 60 using
                                           the 1971 Male Ann&y Mortality Table and an Interest rate of 6 percent Premiums do not include loading
                                           costs.



                                           3Surrendering a life insurance policy means exchanging the policy for all or part of its cash value.



                                           Page 24                                                  GAO/GGD90-31      Taxation   of Inside Buildup
                                         chapter 3
                                         Fmorable   Tu ktanent        of Inside   Bdldup
                                         FiwmagaIuvatmenturIeIlted-




Inside Buildup Not Taxed                 The basic purpose of life insurance is to provide protection against
When Realized on Death of                income loss to beneficiaries who are often dependents of the insured.
                                         The death of the insured terminates the whole life insurance policy. The
Insured but Taxed When                   accumulated interest income or inside buildup in a life insurance policy
Realized as Annuity                      is not taxed when paid to the beneficiary on the death of the insured.
Benefits                                 Death benefits have been exempt from federal income tax on welfare
                                         and humanitarian grounds becausethey are usually paid to a family
                                         that has suffered the loss of the primary earner.4

                                         Liquidation of a deferred annuity terminates the deferral period. Pay-
                                         ment of funds into the annuity has ceasedand payment of funds out of
                                         the annuity begins with liquidation. Unlike the accumulated inside
                                         buildup included in life insurance death benefits, the interest accumu-
                                         lated in annuities is taxed when it is paid out as annuity benefits. Conse-
                                         quently, the inside buildup on deferred life annuities is only tax-
                                         deferred, not tax-free as in the caseof death benefits from life
                                         insurance.
                                         The tax law contains a formula that separates the part of an annuity
                                         payment that is interest, and therefore taxable, from the part that is a
                                         return of principal and not taxable. The IRSformula is easier to use than
                                         actuarial tables, but the result obtained from the formula is only an
                                         approximation. It slightly understates taxable income in the early years
                                         and overstates taxable income in the later years. As a result, in the early
                                         years, there is some additional deferral of tax on annuities. Table 3.3
                                         compares taxable income computed under the IRSformula with taxable
                                         income computed using an actuarial table on an annuity that pays
                                         $10,000 a year. For the first 24 years, taxable income is understated by
                                         about $600 a year and then overstated by about $500 a year thereafter.
Table 3.3: Taxable Income, After
Annuitiration, on a $10,000 Annualized                                                        First 24 yean                Subsequent years
Deferred Annuity Computed Under IRS      IRS formula                                                   $8,718                            $10,000
Formula and Actuarially
                                         Actuarial   formula                                            9,254                              9,514

                                         Note: Computations based on a $10,000 annualized deferred annuity beginning at age 60 and pur-
                                         chased at age 25 with 35 annual premiums. The 1971 Male Annuity Mortality Table was used with an
                                         interest rate of 6 percent.




                                         4These death benefita may not totally   escape taxation since they are included in the tax base of the
                                         federal estate tax and may be subject to state income or estate taxes. The current tax credit for the
                                         federal estate tax, however, is equivalent to about a $600,000 exemption so that the applicability of
                                         thetaxislhnited.
                                                                                   .

                                         Page 26                                                 GAO/GGIHO-31       Taxation   oP Inside Buildup
                             Chapter 3
                             Favorable Tax Treatment of Inaide Buildup
                             Jhcourages Investment4h4ented    Pmdnrts




Surrendering a Life          The cash value received by a policyholder upon the surrender of a life
Insurance Policy or Taking   insurance policy is subject to income tax to the extent that cash value
                             plus any policy dividends previously received is greater than the sum of
a Distribution From an       premiums paid. Thus, the taxation of a full or partial surrender of a life
Annuity Is Taxable but the   insurance policy assumesthat the principal is recovered first and the
Treatment Is Different       interest is recovered afterwards (often termed FIFOfor “first-in-first-
                             out”). That is, any receipt of cash value is deemedto be first a return of
                             premiums paid and only then a return of interest income earned. As a
                             result, partial surrenders need not lead to any payment of tax until the
                             total amount received is greater than the amount paid.

                             Not only is the interest income taxed after the principal has been recov-
                             ered, but the amount that is considered principal for tax purposes is
                             overstated. The calculation of taxable income usestotal premiums paid
                             as a measure of principal. However, part of the premium in each year is
                             used to purchase insurance coverage,and the remainder accumulates as
                             part of the policy’s cash value. As a result, the current method of deter-
                             mining taxable income, which ignores the cost of insurance, overstates
                             the amount of principal on which the inside buildup was earned. Since
                             the principal amount is overstated, the amount of inside buildup taxed
                             is less than the actual amount earned. A more correct basis for calculat-
                             ing the taxable interest accumulation would therefore be the sum of pre-
                             miums paid less the cost of insurance coverage,since it is only excess
                             premiums that are invested at a return and therefore properly consid-
                             ered principal.

                             On the other hand, distributions from an annuity that are over and
                             above the regular annuity payments are taxed as if they were interest
                             income first, at least until all of the interest accumulation has been
                             received. Distributions from annuities are thus said to be taxed on a LIFO,
                             or last-in-first-out basis. That is, any receipt of funds is deemedto be
                             first a return of interest income earned-which is taxable-and only
                             then a return of premiums paid-which is not taxable. In addition, if the
                             annuitant has not yet reached the age of 59-l/2 or fulfilled certain other
                             conditions, an additional penalty tax of 10 percent is assessedon the
                             distribution.




                             Page 20                                     GAO/GGD-30-31   Taxation   of Inside Buildup
                             aupter   3
                             Favorable Tu Treatment of Inside Buildup
                             Enamqp3     Inve8tmentollenti   Producb




Borrowing Against Inside     If a policyholder borrows the inside buildup from his or her life insur-
Buildup Is Tax-Free for      ance policy, the amount borrowed is considered a transfer of capital, not
                             a realization of income, and, therefore, is not subject to taxation. This
Life Insurance but Taxable   reasoning is in accord with tax policy on other types of loans, such as
With a Penalty for           consumer loans or home mortgages. These loans are merely transfers of
Annuities                    capital or savings from one person to another through a financial inter-
                             mediary. The ability to borrow against a life insurance policy means
                             that the interest income that is supposedto be building up to fund death
                             benefits can instead be a source of untaxed current income. If the loans
                             are not repaid, the inside buildup will never be taxed; death benefits will
                             simply be reduced by the amount of the loan. Thus, policyholders have
                             the use of tax-free income for purposes other than insurance at the
                             expense of reduced death benefits for their beneficiaries.5

                             The 1982 Tax Equity and Fiscal Responsibility Act treats a loan from an
                             annuity as a distribution of annuity proceedsfor tax purposes. The
                             amount borrowed is considered a distribution of interest income first
                             and is subject to tax. The purpose of this treatment is to discourage the
                             use of annuities for short-term investment and tax deferral purposes,
                             while maintaining the tax benefits for long-term investment and retire-
                             ment uses. Taxing amounts borrowed reduces the incentive to realize
                             income on a current basis from what is meant to be deferred compensa-
                             tion or savings for retirement. If the annuitant has not yet reached the
                             age of 59-l/2 or fulfilled certain other conditions, a penalty tax of 10
                             percent is also assessedon the amount distributed. Due to the time value
                             of money, it always pays to postpone paying a tax rather than to pay it
                             currently, unless there is some expectation of a significant increase in
                             tax rates in the future. As a result, a penalty is imposed to offset the
                             benefits of deferring the tax on interest income.


Taxation of Policyholder     Roth life insurance and annuities can pay dividends to policyholders to
Dividends Paid on Life       the extent that investment performance is better than a stated or guar-
                             anteed rate of return or to the extent that mortality experience turns
Insurance Differs From       out to be better than expected. Part of the investment income on life
That of Dividends Paid on    insurance policies and annuities can be guaranteed, much like a bond or
Annuities                    some savings accounts, while part of the investment income can depend
                             on performance and is paid at the discretion of the company, as in cer-
                             tain money market or equity instruments. Investment income paid at the

                             5Similarly, homeowners may borrow againat the untaxed equity appreciation in their homes and not
                             pay an income tax on the funds received. However, the interest paid on a home equity loan is tax-
                             deductible, while the interest paid on a life insurance policy loan is not tax-deductible.



                             Page 27                                              GAO/GGD!bO41     Taxation   of Inside Buildup
                     chapter 3
                     Pavorable Tu TreumentofxnddeBl8ibiup
                     EIKmuaga   hlv atment~tedRodaetr




                     discretion of the company is considered a dividend. If such dividends
                     are reinvested and left to accumulate inside a whole life insurance pol-
                     icy, the interest earned on them is taxable. In addition, the dividends
                     themselves are taxable to the extent that the sum of dividends accumu-
                     lated over the life of the policy is greater than the sum of premiums paid
                     by the policyholder.

                     Policy dividends paid on annuities, however, are usually taxable. If
                     earned after the annuity starting date, the dividends are included in the
                     policyholder’s gross taxable income. If earned before the annuity start-
                     ing date, they are taxed unless retained by the insurer as a premium or
                     other consideration paid for the anr~.Gty.~


                     There are both similarities and differences between the tax treatment of
Comparison of Tax    life insurance and deferred annuities and the tax treatment of certain
Treatment of Life    alternative investment vehicles.
Insurance and        In one comparison, the tax treatment of 401(k) and deductible IRA con-
Deferred Annuities   tributions is, in effect, the same as the tax treatment of life insurance
With Other           death benefits.’ F’undsdeposited in 401(k) and deductible contributions
                     made to IRA plans are tax-deductible. These funds and any accumulated
Investments          interest are taxable without penalty when withdrawn from the account
                     after age 69-l/2. F’undsused to purchase life insurance are not tax-
                     deductible, but death benefits-including the accumulated interest
                     income or inside buildup-are not taxed. These two approaches are
                     equivalent in present value terms if tax rates are the same when funds
                     are received as when funds are deposited.8

                     Another comparison showing similar tax treatment is that between non-
                     deductible contributions to IRASand life insurance policies that are sur-
                     rendered. In both cases,the interest income or inside buildup is not
                     taxed as it is earned, but it is taxed when realized-when funds are


                     6Ccmaideradons are the amounta paid lnto annuitlex They are the equivalent of    premiums
                                                                                                            on life
                     insurance pollcles.

                     ‘Deductible IRA contributions are those taken by individuals (single) without a qualified employer-
                     sponsored pension fund or, up to a limit of $2,000, by those with incomes below $25,000. Nondeduct-
                     ible IRA contributions are those taken by everyone else. while the amount conhibuted to such an IRA
                     is not deductible, the interest income is not subject to tax until the IRA ls cashed ln at retirement.

                     *Ekcause the amount paid into a 401(k) or deductible IRA la not taxed, the principal invested is larger
                     by the tax not paid. If this untaxed amount accumulates with interest until withdrawn, the tax on the
                     amount withdrawn will have the same present value as would a tax on the original amount.



                     Page 23                                                 GAO/GGD-@O-31 Taxation      of Lnside Buildup
Ch8pter 3
Favorable Tu Treatment of Inside Builbp
Encores    lnveetment-orlellted Froducta




withdrawn from an IRA at retirement or when the life insurance policy
is surrendered.
Another useful comparison is the similarity in tax treatment of capital
gains, which represent an increase in wealth, and the tax treatment of
accrued interest. Capital gains are not subject to income tax as they
accumulate (or accrue) but are taxable when the underlying asset is sold
and the capital gain is “realized.” This treatment closely parallels the
surrender of life insurance policies becausethe interest accumulation is
not taxed as it accrues but becomestaxable upon surrender to the extent
that the surrender value exceedsthe sum of all premiums paid into the
policy.

The treatment of capital gains at death also resemblesthe treatment of
life insurance death benefits. Neither is included in the income of the
deceased,and the basis for determining capital gains is adjusted for the
beneficiary, effectively removing any tax liability for capital gains that
occurred from the time of purchase through the time of death. Death
benefits paid from a life insurance policy are also not taxable as income
to the beneficiary.

In contrast, some investments are taxed differently. Interest that
accumulates on certificates of deposit is taxable on a current basis even
though the interest may not be realized by the investor until the certifi-
cate matures. Original issue discount bonds are those with low or zero
coupon or explicit interest rates. These bonds, however, have a differ-
ence between the issue price and the value of the bond at maturity. A
set of rules specified in the tax code imputes annual interest amounts on
these bonds, rather than ahowing taxes to be deferred until cash is
received when the bond matures or is sold. In both these cases,interest
is taxed even though no cash is received. The way that income accrues
on original issue discount bonds most closely parallels the way that
inside buildup accrues in life insurance and annuity products.
Table 3.4 summarizes the tax treatment of these alternative forms of
savings, showing the similarities and differences in tax treatment.




Page 29                                    GAO/GGIMXil   Taxation   of Inside Buildup
                                          Favorable Tu htment          of h&de   Bdldnp
                                          ElMmmgmlnvutment-orlente!dFrod~




Table 3.4: Taxation of Instruments Wfth
Accrued Gains                                                       Contribution is           $cx\yd     gain is         Realization of gain
                                          Invertment                taxed                                                is taxed
                                          Life insurance            yes                       no                         yes/noa
                                          Deferred annuities        yes                       no                         yes
                                          Nondeductible IRA         yes                       no                         yes
                                             contributions
                                          Deductible IRA            no, but amount             no                        yes, principal and
                                             contributions          limited                                              interest
                                          401 (k) plans             no, but amount             no                        yes, principal and
                                                                    limited                                              interest
                                          Certificates of           yes                       9s
                                            deposit
                                          Original issue            yes                       yes
                                            discount bonds
                                          Capital gains             yes                        no                        yes/nob
                                          %ealized accrued garn is not taxed when received as death benefits; it is taxed when received on
                                          surrender of the policy.
                                          bAccrueci capital gains are not taxed under the income tax when the owner dies; on the date of the
                                          owner’s death. the asset’s value becomes the benefbary’s new basis for subsequent taxation.


                                          The two aspects in which the tax treatment of deferred compensation
                                          instruments differs most substantially are in “premature” distributions
                                          and borrowing. Premature distribution is the withdrawal of funds from
                                          a retirement instrument before the holder is 59-l/2 years of age, or from
                                          a life insurance policy before the death of the policyholder. Borrowing
                                          from these instruments involves withdrawing funds without forfeiting
                                          benefits if the funds are repaid.

                                          Distributions from IRASand 401(k) plans before age 59-l/2 involve a tax,
                                          including a lo-percent penalty, on the full amount withdrawn except in
                                          very special circumstances, such as the disability of the owner. If the
                                          owner of a deferred annuity takes a distribution during the deferral
                                          period, the amount is taxed with a lo-percent penalty as well. Early
                                          withdrawals from a life insurance policy are usually made by surrender-
                                          ing part or all of the policy. As discussedearlier, early withdrawals can
                                          be taxed.
                                          Borrowing from IFUS is not allowed. Borrowing from 401(k) plans is lim-
                                          ited to one-half of the employee’s accrued benefit in the retirement plan




                                                                                       .

                                          Page 30                                                   GAO/GGIWS31     Taxation   of Inside Buildup
                      Chapter 3
                      Favonble  Tu Trutment      of Inaide holdup
                      Emmmgea    hwstment0riented         Produti




                      up to a limit of $50,000.gBorrowing from annuities is treated as a distri-
                      bution from the annuity and is taxed with a penalty. No tax conse-
                      quencesresult from borrowing from a life insurance policy, and the only
                      limits are the cash value of the policy.


                      Different tax treatment of similar investments creates the incentive to
Implications of Tax   take advantage of those differences. One of the issuesin the recent dis-
Preferences on Life   cussionsof leveraged buyouts is the extent to which tax considerations
Insurance and         might influence those buyouts. Since interest paid on debt is deductible
                      from corporate income and dividends paid to equity holders are not,
Annuity Products      incentives may exist to refinance some of a company’s equity with debt.
                      Incentives can be set up to use financial instruments having many of the
                      characteristics of equity, but which are treated as debt instruments for
                      tax purposes.

                      These incentives have also been an ongoing problem in the area of capi-
                      tal gains taxation. Due to the favored tax treatment, it always paid to
                      get income declared as a capital gain rather than as regular income.
                      Even after the Tax Reform Act of 1986, which rescinded the favored
                      tax treatment of realized capital gains, the favored tax treatment of
                      accrued capital gains remains.

                      The tax preference granted to many forms of pensions and deferred
                      compensation sets up incentives to take income in that form and to dis-
                      guise current compensation as deferred compensation. These incentives
                      require very complicated rules to ensure that what is supposedto be
                      deferred compensation actually is used for that purpose. Complicated
                      rules have been established in the tax code, for example, on distribu-
                      tions from funds and trusts set up to finance deferred compensation or
                      on loans that use deferred compensation as collateral.
                      Similar problems arise.with life insurance and, to a lesser extent, with
                      annuity products. Becauseof the tax-favored nature of life insurance,
                      there are incentives to develop a product that looks like life insurance or
                      can be defined as life insurance for tax purposes. Yet this practice
                      allows people to shelter income from taxation and may, in fact, allow
                      use of that sheltered income on a current basis. To deal with this prob-
                      lem, Congressset up two tests to define life insurance. These tests were
                      established first, on a provisional basis, in the Tax Equity and Fiscal

                      ‘These loans must be repaid within 5 years, unk~ they are wed to finance the borrowing employee’s
                      principal residence.



                      Page 31                                             GAO/GGIMO431      Taxation   of Inside Buildup
clmpter 3
Fwomble    Tax Treatment of hide   Buildnp
Enamragemlnvatmen      t4Mentd   pfmdncu




Responsibility Act of 1982 and then, on a more permanent basis, in the
Deficit Reduction Act of 1984.

Under the law, a contract is considered life insurance if it satisfies either
of two alternative tests. Under the cash value accumulation test, a life
insurance contract’s cash value cannot exceedthe net single premium
neededto pay all future benefits. Under the guideline premium limita-
tion and cash value corridor test, the premiums cannot exceedcertain
guideline levels, and the death benefit cannot be less than a set propor-
tion of the policy’s cash value based on the age of the insured.

These tests may or may not have had the desired effect on life insurance
products that involve more than one large upfront premium, but they
did not appear to effectively limit the use of single premium life insur-
ance products for investment p~rposes.~~As a result, Congressfurther
narrowed the definition of life insurance in the Technical and Miscella-
neous RevenueAct of 1988. The act created a new category of products
called “modified endowment contracts”-any policy funded at a more
rapid rate than seven annual premiums. The act required that loans or
other amounts received from these contracts would be taxable to the
extent of the interest that had built up inside the policies. Thus, single
premium policies would be classified as modified endowment contracts,
and loans from them would be taxable.

This restriction appears, at least for the present, to have cut into the
sales of single premium life insurance. Table 3.5 presents the premiums
earned on single premium and other ordinary life insurance from 1984
through 1988. As a percentage of disposable income, premiums on single
premium insurance rose substantially from 1984 to 1987 but fell by over
50 percent in 1988 compared with 1987.




“For   a more detailed discusion   of the use of single   premium
                                                                policies
                                                                      togetaround    the defuritional
                                                                         /GGD88-9BR,     Oct. 16, 1987,)
                                                                    ce Should Be Restricted (GAO/




Pyle   33                                                   GAO/GGDWb31    Taxation   of Inside Buildup
                                       Favorable Tax Tmatment of Inaide Buildup
                                       Eneoumgealnvastmen   toriented  Pmduetd




Table 3.5: Premiums Earned on Single
Premium and Other Ordinary   Life      Dollars in millions
insurance                                                     Single premium      insurance                 Other ordinary    insurance
                                                                                         Percent of                               Percent of
                                                                                        disposable                               disposable
                                       Year                      Premiums                    income       Premiums                    income
                                       1984                          $1,032                      0.04%       $37,593                       1 41°-
                                       1985                           2,470                      0.09         43,626                       1.54
                                       1986                            5,013                    0.17           46,605                      154
                                       1987                            9.436                    0.29           52.698                      164
                                       1988                            4,800                    0.14           53,217                      153


                                       Preliminary data from the Life Insurance and Marketing ResearchAsso-
                                       ciation (LIMRA) that are based on a sample of companiessuggest that
                                       single premium policy premiums have fallen in the first three-quarters
                                       of 1989 to less than 30 percent of their value for a similar period in
                                       1988. Recently, however, several new products have appeared that com-
                                       ply with the 1988 act but may not be in the spirit of that act.

                                       It is more difficult to analyze whether other investment-oriented life
                                       insurance products are growing and at what rate. Data exist on the sales
                                       of variable life insurance, universal life insurance, and universal varia-
                                       ble life insurance.ll Other than the legal definition, no criteria exist for
                                       distinguishing   which of these types of policies may be “too investment-
                                       oriented*’ from those that are not. As a result, we cannot precisely eval-
                                       uate the implications of the preferred tax treatment on any investment-
                                       oriented policies that satisfy current law.


New Products and New                   The life insurance industry has becomea major competitor in the finan-
Uses of Traditional                    cial services industry. As a result, new products and new usesof stand-
                                       ard products are constantly appearing. One example of a new product
Products                               would be what is called a “combination plan.” This includes an immedi-
                                       ate annuity with a life insurance policy involving 10 annual premiums.
                                       The annuity pays the 10 premiums, but the policy qualifies as a life
                                       insurance product even under the new restrictions and, as a result,
                                       allows borrowing.

                                       ‘lVariablelifeinammce       iaaformofinaumwe     that allows the policyholder to invest his or her cash
                                       value in a mutual fund, with the cash value retkcting the earning experience of that fund. Universal
                                       life insurance allows the policyholder to change the death benefit and the premium payments. These
                                       policies also explicitly distk@sh mortality charges and interest rates that affect the policyholder’s
                                       account. Universal variable offers the policyholder a choice of funds for investing the cash value, as
                                       well as a flexible payment schedule.



                                       Page 33                                                 GAO/GGD9Ml         Taxation   of Inside Buildup
Favorable Tax Treatment      of hide   Buildup
~lnvatment.orientedRodncta




Another new product that especially interested Congressis a policy that
insures two lives, only pays after the seconddeath, and involves seven
annual premiums (the minimum required under the 1988 law). This
product also features a substantial reduction in the death benefit in the
eighth year. The high initial death benefit allows the policy to qualify as
life insurance, but the reduction in death benefits after the seventh y_ear
frees up more funds for investment purposes.

 Both of these products appear to be attempts to comply with the 1988
 act while keeping the main features of single premium policies that the
law intended to curb. Congressdealt with the secondproduct, the 7-year
joint policy, in the recently passedOmnibus Budget Reconciliation Act of
 1989. As a result of this change, any reduction in the death benefit
below what ruled over the first 7 years of the policy requires a recalcu-
lation to seeif the policy still qualifies as life insurance under the
definition.
Examples of new uses of traditional products include “living benefits”
policies and corporate-owned life insurance. Policies that involve living
benefits pay out some designated part of the death benefit while the
insured is still alive, if certain specified conditions are met. These condi-
tions can include the onset of somespecific illness, the certification of a
terminal illness, or the entrance into a qualified nursing home. While
there is little difference between borrowing against a policy and taking a
living benefit, the conditions on the latter are much stricter and the
amounts limited although funds are available sooner.

Many companies insure themselves against the loss of key individuals
(individuals whose death would be costly to the company). Recently, a
new type of corporate-owned life insurance has appeared that involves
smaller amounts of insurance but for larger numbers of employees. The
available data on this phenomenon are quite limited. Currently, only a
few companies sell these policies, so the sample size is quite small. As a
result, the amounts fluctuate from year to year and conclusions are dif-
ficult to draw. For example, LIMRA reports that for a sample of compa-
rues, the number of corporate-owned policies rose by about 70 percent,
while the average face value of these policies actually fell from about
$129,000 to about $57,000 per policy between 1987 and 1988. Compar-
ing the first three quarters of 1989 with a similar period in 1988 but for
slightly different samples shows a 33percent increase in the number of
policies, while the average face value rose from $65,000 to $249,000 per
policy. These policies do not appear to be purchased for the employee or



Page 34                                          GAO/GGKMMXU   Taxation   of Inside Buildup
                             Favorable Tax ‘lkestment   of Inside hildnp
                             Etwomgalnveatment~nted-




                             the dependents of the employee. The company is generally the benefici-
                             ary named in the policies; in many states, the employeesmay not even
                             know that they are insured.
                             While key person life insurance policies were used in the past, policies
                             that involve large numbers of employees do not appear to insure against
                             the loss of particular persons and the economic loss that would be suf-
                             fered by the company with their deaths. Rather, the companies appear
                             to be using the tax-deferred inside buildup and the death benefits to
                             shelter income needed to finance currently unfunded liabilities, such as
                             those incurred for future health benefits. This practice may be, in part,
                             a responseto a new set of accounting rules promulgated by the Financial
                             Accounting Standards Board that would require the costs of future lia-
                             bilities on retiree health benefits to be accounted for on a current basis.
                             In addition, the borrowing privileges allow use of the funds to finance
                             current activities. At present, this type of policy appears to be limited to
                             a few companies. Becausehealth benefits for retirees are projected to
                             grow very rapidly, this method of funding could becomemore
                             widespread.


Implications of Not Taxing   Single premium life insurance policies were a source of concern not only
Life Insurance Borrowing     becauseof the rapid buildup of interest inside the policy, but because
                             they offered the potential for significant future borrowing against that
                             inside buildup. As was discussedearlier, the policy loan is the one aspect
                             of a life insurance policy whose tax treatment differs substantially from
                             that of other deferred compensation items.

                             If the interest rate charged on a policy loan is low compared to market
                             interest rates, a simple and profitable opportunity exists for the policy-
                             holder to borrow the inside buildup at the lower policy rate and reinvest
                             it in something that earns a higher rate. No tax is assessedon such a
                             transaction. Something like this appears to have occurred in the United
                             States between 1965 and 1982. In 1965, policy loans outstanding were
                             about $7.7 billion (less than 5 percent of life insurance industry assets).
                             In 1982, policy loans were $53 billion (about 9 percent of industry
                             asSetS>.

                             In recent years, the difference between the interest rate charged on pol-
                             icy loans and rates that can be earned on investments has narrowed. As
                             a result, outstanding policy loans have not increased, and as a propor-
                             tion of assets,they have decreasedto about 5 percent. However, each
                             year an amount in the range of $9 to $12 billion is borrowed from life


                             Page 35                                       GAO/GGIMO-31   Taxation   of hside   Buildup
                           insurance policies. In addition, the stock of outstanding policy loans still
                           represents about 20 percent of the industry’s ordinary life insurance
                           reserves.

                           One aspect of certain single premium policies that drew attention was
                           that they offered zero net-cost policy loans. The companies offered these
                           loans by crediting to the policy an interest rate that was the same as
                           that charged on the loan. This practice allowed policyholders the option
                           of borrowing the interest accumulation without tax and without any
                           requirement to pay back the loan. The concern generated by investment-
                           oriented life insurance products in general, and single premium policies
                           in particular, led to the introduction of the Stark-Grad&m bill in 1987.
                           The bill would have taxed loans from life insurance policies as distribu-
                           tions in a manner that parallels the treatment of deferred annuities. The
                           staff of the Joint Committee on Taxation estimated that this would have
                           raised about $700 milhon over a 3-year period.

                           Rather than enact the Stark-Gradison biIl, which would have affected a
                           broad range of policies, Congresschoseto restrict its attention to single
                           premium policies. Under the Technical and Miscellaneous RevenueAct,
                           Congressputlimitsontheabihtyto        bo~owagainstsinglepremiumpoli-
                           ties by defining a class of product that was not considered life insurance
                           for tax purposes. This definition excluded any policies that involved
                           fewer than seven annual level premiums. As noted earlier, new policies
                           are being developed that may get around these rules. This circumven-
                           tion is one of the we-         of the definitional approach. If sales of
                           these new products becomesubstantial or if the amount of borrowing
                           from existing policies grows significantly, Congressmay find it neces-
                           sary to tackle the issue of borrowing more directly.


Past Changes in Tax Law    As a rest& of changesenacted in the Tax Equity and Fiscal Responsibil-
Hurt but Recent Changes    ity Act of 1982, borrowing against deferred annuities is presently con-
                           sidered a taxable distribution. In addition, if that borrowing comes
May Have Helped Sales of   before the policyholder is age 59-l/2 or does not meet certain other con-
Deferred Annuities         ditions, a penalty tax of 10 percent is added. As we can seefrom table
                           3.6, this change may have led to a small drop in annuity sales between
                           1982 and 1983. However, since then, these sales have resumed their
                           upward trend. Over the g-year period covered by table 3.6, the sale of
                           individual annuities increased substantially faster than after-tax
                           income, whi.Ie the premiums on individual life insurance rose at about
                           the same rate. There are many possible reasons for this increase in
                           annuity sales. Since the Tax Reform Act of 1986 narrowed the limits on


                           Page 36                                  GAO/GGD3O41Turtbn     ofIn.eideBuildup
                                           Favorable Tu Treata~~~t of Ix&de Buildup
                                           Eneonragulnve8tmul    t4hlent.d Pmlucta




                                           IRASand other tax-preferred deferred compensation items, annuities
                                           have becomemore attractive. An additional source of funds moving into
                                           deferred annuities may be funds that would have gone into single pre-
                                           mium life insurance before the limitations were enacted.
Table 3.6: Salea of lndlvidual AnnultIer
                                           Dollars in millions
                                                                                                  Annulty
                                                                                       conalderatlonr as         lndlvldual insurance
                                                                 Individual annuity   portent of a$---;         premiums as percent
                                           Year                     conrlderatlons                                 of after-tax income
                                           1980                              $6.296                  0.33%                           1.54%
                                           1981                              10,290                  0.48                            1.62
                                           1982                              15,196                  0.67                            1.70
                                           1983                              14,003                  0.58                            156
                                           1984                              15.706                  0.59                            1.45
                                           1985                              20,891                  0.74                            1.62
                                           1986                              26,117                  0.86                            1.71
                                           1987                              33,764                  1.05                            194
                                           1983                              43,784                  1.26                            167


                                           Preliminary indications from LIMRA, basedon a sample of companies,
                                           suggestthat sales of annuities have continued to rise in 1989, though at
                                           a slower rate than in recent years.




                                           Page 37                                         GAO/GGD9O-31     Taxation   of Inside Buildup
Chapter 4

The Inside Buildup Debate


                    The issue of how to treat the inside buildup of life insurance and annu-
                    ity products has been debated for decades.One argument for keeping
                    the present tax treatment is that there is no special treatment because
                    no personal income is truly available in an ongoing life insurance policy.
                    Other arguments acknowledge the income but suggestthat there are
                    good policy reasonsfor granting special treatment.

                    To those who favor full taxation, the fundamental issue is that inside
                    buildup is income that should be taxed on a similar basis as other earned
                    income. Other arguments in favor of taxing inside buildup generally
                    point to evenhanded treatment acrossfinancial instruments and institu-
                    tions or the idea that particular social goals can be better achieved with
                    more careful targeting of tax preferences or government spending.


                    Economic income for a household is defined as the sum of its consump-
Inside Buildup Is   tion spending plus the change in its net worth over a period of time.
Income              According to this definition, the interest that accumulates on a life
                    insurance policy is income-though income that may not be received in
                    cash. As interest accumulates on a life insurance policy, other income is
                    not needed to provide for future needs,thus freeing up these other
                    resources for current use.

                    Unless some or all of the policy is surrendered or an annuity or loan
                    received, no cash income is available to the policyholder. One reason for
                    not taxing the accrual is that no actual cash flows to the policyholder or
                    annuitant in the absenceof some realization, such as surrendering a pol-
                    icy. Someonemay be subject to a tax without having sufficient funds to
                    pay the tax. This issue arises in the related context of taxing accrued
                    capital gains. Taxpayers might incur such large capital gains and subse-
                    quent taxes that they would be forced to sell the assetsto pay the taxes.

                    A related argument of life insurance companies is that they are trustees
                    for their policyholders, and thus, the interest that builds up is not really
                    owned by the policyholder or annuitant. While certain charges are
                    imposed on early surrender, the policyholder has accessto the funds
                    through (1) fully or partially surrendering the policy or (2) borrowing
                    the funds. The annuitant can take funds out of the annuity, borrow
                    funds from the annuity, or liquidate the annuity. Even if the policy-
                    holder or annuitant does not exercise the option of gaining cash, this
                    does not mean that the interest accrual is not income, only that it is not
                    cash income.



                    Page 38                                  GAO/GGD-WI    Taxation   of Inside Buildup
                        w-4
                        ‘he Inside Buildup   Debate




                        Taxing the interest accruing on whole life insurance policies or annuities
                        would be similar to the current taxation of interest accruing on certifi-
                        cates of deposit (when the interest is reinvested in the certificate) and
                        original issue discount bonds. In both cases,the income is taxed even
                        though no cash is received to pay the tax. Inside buildup is more like
                        accrued interest than it is like accrued capital gains. Measuring accrued
                        capital gains, in the absenceof a sale of the assetor similar assets,may
                        be a problem. In addition, capital gains are much more volatile and can
                        increase or decreasesubstantially from year to year. Inside buildup is a
                        steady, measurable increment each year.
                        Similarly, the prospects for taxpayers not having enough cash to pay a
                        tax on accrued inside buildup should not be greater than currently
                        exists for the tax on accumulating interest income. In both cases,funds
                        may be withdrawn, if necessary,to pay the tax. In addition, inside
                        buildup is unlikely to generate such a large taxable amount that an indi-
                        vidual would be forced to surrender a policy to pay the tax. For exam-
                        ple, a 45year-old with a $100,000 life insurance policy that was
                        purchased at age 25 and is accumulating interest at 5 percent would
                        generate interest income of about $850 in that year. In 1984, Treasury
                        estimated that the average annual inside buildup, for those with cash-
                        value life insurance policies, was about $365 per family in 1983.

                        We believe that inside buildup is income and could be taxed without any
                        more hardship than that imposed by the tax on other forms of interest
                        income.


                        Becauseinside buildup is not subject to current taxation, the rate of
Tax Preference May      return to saving through the life insurance policy or deferred annuity is
Encourage Saving        likely to be higher than if this interest were subject to tax. Whether the
Through Life            rate of return is higher or lower than the after-tax return provided by
                        other savings alternatives is uncertain. Becausepart of the premium
Insurance Companies     goestoward purchasing insurance protection, the rate of return for life
but Has Little Effect   insurance is not as high as it would be if alI of the resourceswere accu-
                        mulated. As a pure investment vehicle, standard whole life policies are
on Total Saving ,,      not very attractive. However, since they provide insurance protection
                        along with the investment potential, they can be quite attractive.

                        If inside buildup were subject to current taxation and this, in turn,
                        reduced the rate of return on life insurance and annuity products, the
                        amount saved through the life insurance industry would probably be
                        reduced. However, total saving is not likely to be affected very much.
                                                       .

                        Page 39                                 GAO/GGD9031   Taxation   of Inside Buildup
                       clmpter 4
                       The Jmdde Buildup   Lkbate




                       The effect on total saving would depend upon whether the funds that
                       moved out of the life insurance industry were spent or saved elsewhere.
                       Alternative savings instruments are available other than whole life
                       insurance or deferred annuities to provide for dependents or for one’s
                       own retirement. While some funds may be consumed,it is likely that a
                       substantial part will remain as savings.

                       One last argument for saving through life insurance is the so-called
                       “forced saving” argument. People may know that they would like to
                       save a particular amount or a particular proportion of their income.
                       However, they may also believe that if they make decisions on how
                       much to save or consumeon a monthly basis, they will always consume
                       more than they “should.” As a result, they might lock themselves into a
                       savings plan that will require them to save some amount each pay
                       period or, at least, make it very difficult to not save some amount each
                       period. If this forced saving component is important and no alternative
                       vehicles exist for forced saving, moving funds out of the life insurance
                       sector could reduce total savings.

                       Since it is very difficult to quantify the extent to which life insurance
                       saving is “forced,” it is difficult to evaluate the importance of the
                       “forced saving” argument. In addition, other ways are available that
                       allow‘people to force themselves to save, such as retirement plans and
                       payroll deduction devices. The net effect on total savings of reducing
                       forced saving through life insurance is, therefore, unclear.


                       As a major financial intermediary, the life insurance industry provides a
Tax Preference         service by lending for a longer time than it borrows. It provides long-
Increases Long-Term    term financing to those who borrow funds from the industry. At the
Panital   lTqm&-on     same time it provides insurance or annuities along with a certain
                       amount of liquidity to its lenders who are the policyholders and annuity
r mancea by the        owners. This liquidity allows these lenders to receive cash, should they
Insurance Sector but   need it, without being forced to sell other assetsand potentially suffer a
                       substantial capital loss.
Not for the Entire
Economy                However, other financial institutions provide similar fiiancial services.
                       To argue for special tax treatment for the life insurance industry rela-
                       tive to other financial institutions, it is necessaryto argue that the
                       insurance industry is better at allocating invested funds from society’s
                       standpoint than are these other institutions. If the insurance industry
                       were more efficient and profitable, ensuing returns would reflect this
                       and the market would provide more        funds to the industry without a
                                                          .

                       P8ge 40                                 GAO/GGDBO-31   Taxation   of Inside Buildup
                         ChApter 4
                         The Inside Buildup   Debate




                         need for subsidy or tax preference. If the benefit to society is that the
                         life insurance industry takes a long-term perspective or that its invest-
                         ments generate extra returns to society, there would be no reason to
                         restrict the tax preference to whole life insurance policies or deferred
                         annuities. The argument for some form of tax preference would also
                         hold for term insurance, immediate annuities, or any other product sold
                         by the life insurance industry. The purpose of the tax preference would
                         be to get more funds into the hands of more efficient investors and not
                         to limit the preference to only a subset of products.
                         Overall, no evidence suggeststhat investment by the life insurance
                         industry is in any way more socially beneficial than the investment of
                         other financial intermediaries. Becauseinside buildup is not taxed as
                         current income, life insurance companies attract more funds for invest-
                         ment at the expense of other financial institutions whose interest pay-
                         ments are taxable to the depositor. Since there does not appear to be any
                         clear evidence that life insurance companies are more efficient investors
                         than other institutions, too many resourcesmay be invested in life insur-
                         ance companies and too few in other institutions.


                         The primary purpose of life insurance is to replace income lost due to
Insufficient Provision   the death of the insured. There are a number of reasons why the amount
for Beneficiaries’       of insurance purchased may not be adequate for the purpose. If a family
Future Needs Provides    has a low income, for example, it may be very difficult for the family to
                         put money aside to provide protection for dependents in casethe pri-
Primary Support for      mary earner dies. Families with below average income might
Tax Preference           under-purchaselife insurance, and dependents in these families could, as
                         a result, be under-protected.However, this does not appear to be the
                         CaSe.


                         In the ownership study done by LIMRA for 1984,69 percent of house-
                         holds with incomes under $15,000 owned life insurance compared with
                         81 percent of households at all income levels. While the percentageof
                         low-income households covered was below average, the amount of cov-
                         erage by those households with insurance was above average. House-
                         holds with incomes below $15,000 had coveragethat was about 2.8
                         times annual income, while the average for all households was about 2.5
                         times income. While fewer low-income families purchase life insurance,
                         the amounts they purchase- in relation to their income-tend to be
                         larger.




                         Page 41                                 GAO/GGDgo31   Taxation   of Inside Buildup
In order for the special tax treatment of inside buildup to provide lower
cost insurance to low-income households,the individual involved must
at least be a potential taxpayer. If the individual’s income is low enough,
there will be no tax liability and, therefore, the tax break will be useless.
The greatest benefit from this tax break would go to those in the highest
marginal tax brackets, and these are not low income households.For
example, Treasury reports that in 1983 fewer than 25 percent of fami-
lies with incomes of $15,000 per year or less had life insurance of the
type involving inside buildup.1 This compares with 42 percent of fami-
lies at all income levels who owned this type of insurance.

In addition, a major source of replacement for the lost income of low-
income groups comesin the form of survivors’ benefits paid by the
Social Security Administration. As is true of all Social Security benefits,
lower income groups get a better return for their contributions than do
higher income groups. Someevidence shows that these benefits have
reduced the amount of life insurance in force (the total face value of
existing life insurance policies), though how much effect it has had on
low-income groups is unclear.

Other concerns about the adequacy of life insurance protection have less
to do .with household income. One important concern is that people do
not have sufficient foresight to plan for the contingenciesof the future.
It is difficult to know how much income one will have in the future, and
how many people will be dependent on that income. While additional
insurance can usually be purchased, it is generally more expensive the
longer the delay. It may be difficult to know how much insurance is
required to allow dependents to maintain a particular standard of living
due to changesin inflation rates and other macroeconomicchanges.
Also, since most life insurance is purchased by the insured rather than
by the potential beneficiary, dependents may find that the amount of
insurance purchased is insufficient for their needs.

Although a number of studies have been done on the adequacy of life
insurance coverage,the evidence regarding the adequacy of this cover-
age is inconclusive. One study indicated that low-income groups had
adequate protection-at least as defined by the study and for the period
examined-as a result of both purchases of life insurance and the Social



‘Tax Reform For F alrness, Simplicity,   and Economic Growth, Vol. 2 Department      of the Treasury,
&ember     1964, p. 262.




Page 42                                                 GAO/GGDfXMl       Taxation      of Inside Buildup
                       chapter 4
                       The Inside Buildup   Debate




                       Security system and that higher income groups also had sufficient pro-
                       tection. A broad range of middle-income people, however, did not appear
                       to have adequate coverage.
                       According to an ownership study by the Life Insurance Marketing
                       ResearchAssociation, middle-income families with life insurance had
                       protection that averaged about 2.4 times their annual income. This ratio
                       is less than the coverage ratio recommendedby some industry authori-
                       ties, which was 4 to 5 times annual income. In addition, since about 90
                       percent of middle-income households had life insurance, for all middle-
                       income families, the ratio of life insurance coverageto annual income
                       was closer to 2. A more recent study indicates that coveragemay be
                       adequate when the costs and benefits of insurance are carefully com-
                       puted. If the adequacy of existing coverageis difficult to evaluate, it
                       would be even more difficult to estimate the effect that taxing inside
                       buildup would have on life insurance coverage.


                       Outstanding policy loans reduce the value of a life insurance policy’s
Policy Loans Defeat    death benefit; thus, loans not paid back before the death of the insured
Purpose of Life        defeat the purpose of life insurance. Becausethe company cannot force
Insurance and Should   the policyholder to repay the loan-it is after all the policyholder’s
                       money-loans could be restricted or considered realizations of income
Be Taxed               first and considered principal second.This practice would make the tax
                       treatment of life insurance consistent with that of other forms of
                       deferred compensation, including annuities. However, restricting the
                       ability to borrow against policies may reduce the demand for those poli-
                       cies. If existing life insurance coverageis inadequate, this could make
                       that coverage even less adequate.

                       In 1988, Congressrestricted borrowing on certain types of life insurance
                       policies. One purpose of these restrictions was to limit the potential for
                       borrowing on single premium life insurance policies at zero or very low
                       rates. Congressimposed the restrictions not by explicitly limiting the
                       ability to borrow against life insurance but by altering the definition of
                       what constitutes life insurance. The effect was to create a type of policy
                       with very restrictive borrowing privileges, much like those of annuities.

                       While these changeslimited borrowing on policies with fewer than
                       seven annual premiums, they did not directly deal with the broader
                       problem of borrowing against the cash value of any whole life policy.
                       This borrowing is the one tax advantage that life insurance retains over
                       other forms of deferred compensation. In this way, the life insurance


                       Page 43                                 GAO/GGDW31   Taxation   of Inside Buildup
              CM=4
              The Indde   Buildup   Debate




              industry could be said to have a tax advantage over other industries
              offering deferred compensation instruments.


Conclusions   ties, the federal government forgoes $6 billion a year in potential tax
              revenue. While imposing a tax on the inside buildup could pose cash
              flow problems for some taxpayers becausethey will be taxed on income
              that they have not yet received in cash, the buildup is income and there-
              fore could be part of the income tax base.

              The only reason for not taxing inside buildup that we found to have
              merit is that doing so would reduce the amount of life insurance cover-
              age that some people buy. Protecting survivors against income loss is a
              goal that society has traditionally supported. The primary question then
              is whether the increased revenue generated from taxing inside buildup
              would outweigh the costs to society of reduced insurance protection,
              including the possibility of direct government provision of income pro-
              tection for dependents. Becausepatterns of life insurance ownership
              and the types of products available can change,Congressmay wish to
              periodically reexamine its policy decision to forgo taxing inside buildup,
              weighing the social benefits against the revenue loss.

              It may be preferable to give the tax advantage to those who would sub-
              stantially reduce their coveragein the absenceof the tax advantage, and
              not give the advantage to those who would purchase sufficient insur-
              ance even without the incentive. Unfortunately, it is very difficult to
              provide a targeted incentive for something that would not have occurred
              without the incentive and not to provide incentives for activities that
              would have occurred anyway.

              High-income people would probably be able to protect their dependents
              without any tax preference and lower income groups are usually pro-
              tected by Social Security benefits. In Tax Reform for Fairness, Simplic-
              ity, and Economic Growth, the Treasury Department proposed a way of
              limiting the tax preference for inside buildup by including the cash
              value of life insurance within the IRA ceiling. others have proposed lim-
              iting the amount of tax-deferred interest that a taxpayer may claim.
              Restrictions such as these, though possibly cumbersomeand difficult to
              administer, are feasible and would probably save the federal govem-
              ment some revenue. We have not done any analysis of the relative costs
              and benefits of such restrictions and, as a result, cannot evaluate these
              proposals. Congressmay wish to examine this area if it choosesto


               Page 44                                GAO/GGDWl    Taxation   of Inside Buildup
Chpm4
‘he Inside Buildup   Debate




revisit the policy decision to grant preferential tax treatment to inside
buildup.
The effect of this special tax treatment on the national savings rate is
ambiguous. While the after-tax rate of return on funds invested in life
insurance and annuity products is probably higher than it would be if
taxable, it is not clear that it is higher than after-tax rates on taxable
instruments that do not provide insurance or annuity protection. Even
so, the effect of after-tax rates of return on saving is, in general, not
clear. Only if a substantial amount of the saving is “forced” is there
likely to be much in the way of additional saving. No evidence shows
that the life insurance industry is any better than any other segmentof
the financial sector at making efficient investment decisions.
The inside buildup on life insurance and deferred annuities is treated
similarly, under current tax law, as long as the funds remain in the
product. However, tax law treats funds that are withdrawn or borrowed
from a life insurance policy differently from funds withdrawn or bor-
rowed from an annuity. The proceedsof a life insurance policy can be
borrowed unconditionally and without tax, while the proceedsof
deferred annuities can only be borrowed if a tax and a penalty are paid.
Other deferred compensation instruments allow borrowing without tax-
ation only under certain stringent conditions, otherwise a tax and pen-
alty are imposed.

Until now, Congresshas chosento deal with concerns about potential
misuse of the tax preference associatedwith inside buildup by narrow-
ing the definition of what qualifies as life insurance. The definitional
approach involves two dangers. F’irst, the definition may not be narrow
enough. Policies may qualify that are primarily oriented toward produc-
ing investment returns rather than insurance protection. Second,the
definition could be too narrow. Products serving a legitimate life insur-
ance need may be disqualified.

An alternative to the definitional approach would deal with the con-
cerns more directly. Taxing the accumulated interest would remove the
need for defining life insurance in the tax code, since there would no
longer be any advantage to qualifying as insurance. The effect of this
would be an extreme version of the overly strict definitional approach-
that is, the tax preference would not be available for products that
serve a legitimate life insurance purpose. An alternative would be to
limit or eliminate the ability of policyholders to gain accessto their



Plrge 45                                 GAO/GGD!XMl   Taxation   of Inaide Buildup
                 clupter4
                 The hide   Ekdldnp Debate




                 inside buildup without paying a tax. Taxing or placing limits on borrow-
                 ing is a way of achieving these goals.

                 The ability to borrow against a life insurance policy is an attractive fea-
                 ture. Limitations on that feature may causesomebuyers to reconsider
                 the amount of life insurance that they wish to purchase. Unlimited bor-
                  rowing allows the policyholder accessto income without paying any tax
                  and reduces the death benefit. Thus, we believe that borrowing against
                  life insurance proceedsshould be considered a realization of income sub-
                 ject to tax. The buildup is no longer inside the policy, and the basis for
                 tax deferral no longer exists. If this serves to reduce borrowing, death
                  benefits will be protected against what could be perceived as shortsight-
                 ednesson the part of the policy owner. If it does not reduce borrowing,
                  income will be taxed as it is realized. An added advantage of taxing life
                 insurance borrowing is that it would reduce the incentive to construct
                  life insurance policies, like single premium life policies that were
                 designed for investment and not insurance purposes. Since repayment of
                 borrowed amounts restores the death benefits, any amount that was
                  included in taxable income when borrowed should be deductible if and
                 when repaid.


                 Becausethe pattern of policy usage as well as the type of products
Recommendation   offered can change, Congressmay want to periodically reconsider its
                 policy decision to grant preferential tax treatment to inside buildup,
                 weighing the social benefits against the revenue forgone.

                 If Congressdecides not to tax inside buildup, then GAO recommendsthat
                 Congresseliminate tax-free borrowing of life insurance proceeds.Any
                 borrowing of these proceedsshould be considered a distribution of inter-
                 est income. To offset the advantages of accruing interest income without
                 tax, a penalty provision needsto be added to the regular tax. Since
                 repayment of the amount borrowed restores the death benefits, any
                 amount that is taxed when it is borrowed should be tax deductible if
                 subsequently repaid.


                 GAO obtained   oral comments from industry representatives on this
Comments         report. Industry representatives stated that in their opinion, the current
                 tax treatment of inside buildup is justified. They believe that recent
                 changesin the tax laws have remedied serious abuses.They said that
                 traditional life insurance products are not overly investment-oriented,
                 although some of the single premium
                                                .       policies may have been. The


                 Page 48                                 GAO/GGIM30-31Taxation   of hide   Buildup
chp-4
Tlte hide   Buildup Debate




changesmade in 1988, however, effectively closed any loopholes. In
their view, loans are a legitimate part of the life insurance product and
are generally used to serve important social goals, such as financing a
home or paying college tuition. Therefore, there is no need to place any
restrictions on these loans.




Page 47                                 GAO/GGIWO31   Taxation   of Inaide Buildup
Appendix    I

Cakulation of Excess Premiums on Whole
Life Insurance

                                       Excesspremiums arise in the early years of a whole life insurance policy
                                       becausethe annual premium is greater than the cost of the actual insur-
                                       ance coverage.As shown in chapter 2, the excesspremiums are invested
                                       by the insurance company and earn interest income for the policyholder;
                                       the sum of the excesspremiums and interest income built up is a policy’s
                                       cash value. The face value less the cash value is the amount of actual
                                       insurance coverageprovided by the policy for that year. The premium
                                       paid less the cost of the actual insurance coveragefor a given year
                                       equals the excesspremium for that year. The cost of the actual insur-
                                       ance coverage for a given year is the premium that would have to be
                                       paid for a l-year term policy giving the same coverage.Table I.1 shows
                                       how the excesspremiums grow in the early years of a policy, when the
                                       cost of the actual insurance coverageis less than the premium, and then
                                       becomenegative as the cost of the actual insurance coveragebecomes
                                       greater than the premium. The calculations are based on the $100,000
                                       annual premium whole life policy presented in chapter 2.
Table 1.1: Calculation of Yearly and
Cumulative Excess Premiums on a                                        Actual                    Annual       Cumulative
$1 W,ooO Annual Premium Whole Life                       Annual    insurance       cost ot       excess           excess
Policy                                 Age             premium      coverage    insurance      premium         premiums
                                       25                  $676      $99,466         $168            $508             $508
                                       35                   676       92,381           186            490            5,609
                                       45                   676       82,095           356            320            9,699
                                       55                   676       68,509           683              (7)         11,326
                                       65                   676       52.344         1.191           (515)           8.335
                                       75                   676        35,759        2,186         (1,510)           (2,169)
                                       85                   676        22,243        3,240         (2,564)         (22.936)
                                       95                   676        10,717        3,368         (2,692)         (51,258)
                                       99                   676             0            0              0          (58.557)


                                       The annual excesspremium begins at $508 at age 25 and declines gradu-
                                       ally over the years until it turns negative at age 55. At this age, the
                                       cumulative excesspremiums reach a maximum of $11,326. After age 55,
                                       the cost of the actual insurance coverage is greater than the annual pre-
                                       mium, and the annual excesspremium turns negative. At this time, the
                                       cumulative excesspremiums are used to supplement the annual pre-
                                       mium. By age 75, however, the cumulative excesspremiums are used
                                       up; the inside buildup (interest income) is then used to supplement the
                                       annual premium in order to cover the cost of the actual insurance
                                       coverage.




                                       Page 40                                  GAO/GGD9%31   Taxation   of Inside Buildup
Appendix II

Major Contributors to This Report


                        Paul L. Posner, Associate Director, Tax Policy and Administration Issues
General Government      Natwar Gandhi, Assistant Director
Division, Washington,   Larry Korb, Assignment Manager
D.C.                    Tom McCool, Economist-in-Charge
                        MacDonald R. Phillips, Economist
                        Bill Simpson, Actuary




(268401)                Page 49                                GAO/GGD9031   Taxation   of inside Buildup
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