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Section 7702 Got a Makeover for 2021 and What it Means for Whole Life, UL, and IUL Policies

As though the changes that AG49-A brought to IUL illustrations this past November weren’t enough to shake up the industry, something very big was packaged in the HEROES Act by congress at the end of 2020.  Section 7702, passed in 1988, is where the IRS etched in stone interest rates for policies of 4% for CVAT/MEC and the GPT Level Premium and 6% for GPT Single Premium.  Regardless of future interest rate fluctuation, these values were permanent and remained unchanged for the next 32 years!  But as with seemingly everything else in life, 2020 turned its tidal forces on 7702 in a last-gasp effort to close out the year.  What happened? And what does it mean for your current and future policyholders?  Let’s take a swim.

Quick Glance for What’s In This Article:

  • Existing Rates for Whole Life and UL policies of 4% and 6% will be lowered for new policies to 2% for 2021 and then will float with the interest rate after 2021
  • Premiums to fund cash accumulation policies will increase
  • MEC designation under the new rates will allow for higher premiums

Section 7702: Unsustainably Flawed Policy and the Glass House of Guaranteed Benefits

The 1980s were a wild time for our industry.  TEFRA and DEFRA  regulations sought to rein in cash accumulating insurance policies by defining strict rules on what could be considered life insurance.  This gave way to the concept of a Modified Endowment Contract (MEC) that the IRS could use as a guidepost for how much premium could be put into a policy while still remaining tax-free.  

They established the 7-pay test which set limits on how much money could flow into a policy without being taxed as an annuity.  Additionally, in 1988, they added Section 7702 to the IRS tax code.  Section 7702 established interest rates for the life insurance industry.  These rates were 4% for CVAT/MEC and GPT Level Premium and 6% for GPT Single Premium.  Essentially, these rates would determine the guaranteed growth of premiums over time.  

Along with the 7-pay test which held that the highest allowable amount of premium must not exceed the amount of premium necessary to pay up the death benefit in 7 years.  This was actually part of the TAMRA act of 1988.  The point of the 7-pay test was to prevent people from abusing their life insurance policy to avoid paying taxes.  It set a limit.  Section 7702 helped realize that limit by assuming a growth of 4% or 6% interest over the life of the policy.

But there was one major flaw…

The problem with Section 7702 lay in the fact that these interest rates were permanent and did not ebb and flow with the changing interest rates of the rest of the economy.  This was all well and good back in 1988, but over the next 30 plus years interest rates went down and they went down dramatically.  Today they are between 1% and 2%.

smashing glass insurance rate changes in section 7702

7702 Revised: The Hammer

In the waning hours of 2020, congress passed a Covid-19 focussed act called the HEROES Act.  Like many acts that pass through congress, it had many items that weren’t related to Covid-19 including a dramatic and possibly long overdue change to Section 7702.  Bolstered and lobbied for by ACLI and Finseca, Section 7702 got a facelift and the rates were reestablished at 2% for the year 2021 followed by a floating interest rate moving forward.  Suddenly, cash accumulation policies were caught up with the actual interest rate with very little fanfare made of this monumental adjustment.  

What the Changes to 7702 Mean for Producers and Policyholders

First off, let us say that this change to Section 7702 would likely have become necessary the longer interest rates hovered so close to 1%.  This shift to a floating rate will allow insurance products to weather more diverse economic landscapes into the future.  Immediately, however, it is a seismic shift in how we view the value of guaranteed benefits versus non-guaranteed benefits.  It also has significant implications for max-funded UL policies.  

Here’s the most obvious shift.  The 7-pay test assumed growth at 4% or 6% of premiums to fund the death benefit.  By lowering these down to 2%, it means that higher premiums will be required to fund the policy.  This means that a new policyholder can put more premium dollars in without triggering the MEC designation.  Ultimately this will result in more efficient cash accumulation for the policyholder over time.  

For producers, the results of this shift in rates are yet to be determined.  It is likely that guaranteed benefits will become less significant in the sales approach for these policies and we imagine that non-guaranteed benefits will receive more attention in illustrations. 

We are Committed to Keeping You On Top of the Latest Developments

Trust Financial is committed to your growth and success.  We are also dedicated to helping you stay on top of these new developments as they happen in our industry so that you can continue to provide expert guidance to your clients.  We are here for you.  Check out this article by Bobby Samuelson for a more comprehensive breakdown of what the overhaul of Section 7702 means for the future.  

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