What Happens When Cash Value Exceeds Death Benefit?
Learn how cash value growth in life insurance affects your policy's tax treatment and the strategies to manage it effectively.
Life insurance policies provide a death benefit to beneficiaries. Permanent life insurance policies also feature a savings or investment component known as cash value. This cash value grows over time and offers financial flexibility to the policyholder during their lifetime. Understanding the relationship between a policy’s cash value and its death benefit is important for policyholders.
Understanding Cash Value and Death Benefit in Life Insurance
Cash value life insurance policies, such as whole life or universal life, combine a death benefit with an accumulating cash component. A portion of each premium payment contributes to this cash value, which grows on a tax-deferred basis through interest or dividends. Policyholders can access this accumulated cash value through policy loans, withdrawals, or by surrendering the policy.
The death benefit is the amount paid to beneficiaries upon the insured’s passing. This payout is typically income tax-free for beneficiaries. The cash value within the policy can be used to help pay for policy costs or may increase the total death benefit.
How Policies Maintain a Death Benefit Corridor
Life insurance policies must adhere to specific Internal Revenue Service (IRS) guidelines to maintain their tax-favored status. Internal Revenue Code Section 7702 defines what qualifies as a legitimate life insurance contract, distinguishing it from an investment vehicle. These rules prevent policies from being primarily used as tax-sheltered investment accounts rather than for their intended purpose of providing life insurance coverage.
A crucial aspect of these guidelines is the “death benefit corridor” or “cash value corridor.” This corridor ensures the death benefit remains sufficiently larger than the cash value. If the cash value grows too large relative to the death benefit, the policy risks losing its tax advantages. The IRS employs the “7-pay test” to prevent excessive cash value accumulation relative to the death benefit. This test compares total premiums paid within the first seven policy years to a calculated limit; exceeding this limit can trigger adverse consequences.
Consequences of Exceeding Funding Limits
When a life insurance policy’s cash value growth or premium funding violates IRS guidelines, particularly by failing the 7-pay test, it becomes reclassified as a Modified Endowment Contract (MEC). This reclassification is permanent and cannot be reversed. Once a policy becomes an MEC, it loses many of the favorable tax benefits, and its tax treatment becomes similar to that of a non-qualified annuity.
One significant tax implication for MECs is the “Last-In, First-Out” (LIFO) taxation rule. This means withdrawals, loans, and partial surrenders from an MEC are considered to come from taxable gains first, before any of the principal (premiums paid). These gains are then taxed as ordinary income. In contrast, non-MEC policies typically allow withdrawals of principal first, which are generally tax-free up to the amount of premiums paid.
Distributions from an MEC made before the policyholder reaches age 59½ are subject to an additional 10% federal penalty tax on the taxable portion. This penalty is similar to early withdrawals from retirement accounts, with limited exceptions such as disability. Policy loans from an MEC are also treated as taxable distributions, unlike loans from non-MEC policies which are generally tax-free.
Managing Policy Cash Value Growth
Policyholders have options to manage their cash value growth and avoid unintended MEC status. Adjusting premium payments is one such strategy; reducing or stopping payments can slow the accumulation of cash value. Policyholders may also consider increasing the death benefit of their policy, if permissible, to widen the death benefit corridor. Increasing the death benefit may also lead to higher policy costs.
Understanding the specific mechanics of one’s policy is important, including how premiums contribute to cash value and how this relates to the death benefit. Regularly monitoring policy performance and consulting with a financial advisor or insurance agent can help ensure the policy remains compliant with IRS regulations. Policyholders should also carefully consider the tax implications before accessing cash value, particularly if the policy is an MEC, to avoid unexpected tax liabilities or penalties.