House Panel Votes for a Good ‘Policy’

There was good news from Congress last week for people who have purchased single-premium or similar investment-oriented life insurance recently.

Although the House Ways and Means Committee voted to restrict policyholders’ ability to draw money out tax-free, it passed a “grandfather” provision that would protect policies that were in place on June 21.

The clause also would exempt from penalty premiums and other payments paid into existing policies if the terms of the policy required such payments. Voluntary payments would be subject to the new rules.

The committee’s bill is far less severe than that proposed by Reps. Fortney H. (Pete) Stark (D-Calif.) and Willis D. Gradison Jr. (R-Ohio), which would have grandfathered only policies written before last October.

However, if you are thinking of taking out an investment-oriented policy, you would be well-advised to wait and see how the final bill comes out.

There is widespread agreement in Congress that single-premium policies and their relatives ought to be restricted, but the debate so far has focused on how to construct a formula that gets at the abuses without wiping out conventional whole-life policies.

The committee adopted a plan that, in effect, looks at the investment component of a policy and compares it with the insurance component.

All whole-life policies have both components. In traditional whole life policies, the premiums are the same over the policy period. The premiums in the early years more than cover the insurance cost, and the extra is invested. In later years, the investment earnings keep the premiums level as the policyholder grows older and the insurance cost rises. In single-premium and other “limited payment contracts,” the buyer makes a small number of payments, perhaps only one, in the early years. The policy is so heavily weighted toward the investment side that no further premiums are necessary.

Ways and Means Chairman Dan Rostenkowski (D-Ill.) had sought a “20-pay” formula, meaning that any policy whose investment component exceeded that of a 20-year level-payment policy would be subject to taxes and penalties if the policyholder took out any of its cash value through loans or withdrawals.

The panel finally adopted a “seven-pay” formula, so a policy would have to have at least the investment structure of a seven-year level-payment policy. Policies that fail this test would be dubbed “modified endowments” and withdrawals and loans from them would be taxed. In addition, money taken out before age 59 1/2 would be subject to an additional 10% penalty tax.

The insurance industry said the formula “clearly and effectively addresses the investment abuses.” But Rostenkowski and others on the panel are not so sure, so the committee vote is unlikely to be the last word on the issue. The Treasury Department and others say that anything less than a 10- or 12-pay test will not eliminate the problem. The Senate Finance Committee has not yet begun writing its tax bill.

Insurance companies are undoubtedly at work on policies that would meet the seven-pay test, but that may not be the formula that becomes law.