Looting the Treasury to Benefit Big Insurance

Do you know how much the cuts in Social Security benefits now getting debated in Congress will ‘save’ America? Not nearly as much as a tax loophole that benefits the wealthy and the insurance industry costs America.

The second in an Inequality.Org series on the giant pool of assets in America that produce income not currently subject to taxation

By Bob Lord

Insurance companies and the wealthy they service have so far squashed attempts to eliminate the permanent life and annuity policy loophole.

Our tax law has several bedrock principles. Among them: We must not elevate form over substance in applying the tax law. Put differently, we must not let taxpayers avoid tax through sheer artifice.

But Congress, unfortunately, has enacted exceptions to our bedrock rules, including a very expensive exception for permanent life insurance and annuity policies.

A little background. Life insurance policies fall into two categories: permanent and term life. With term insurance, you enter into a contract with an insurance company that has you pay a stated amount for the length — the term — of the policy. If you should you die during that term, your heirs receive the agreed-upon death benefit.

Typically, you have the right to renew a term policy, but the cost to obtain the same death benefit increases, for obvious reasons, as you age.

Permanent life insurance essentially combines term life insurance and an investment account the insurance company manages for you. In the early years of a policy, your premium breaks down into two parts. One pays the cost of the term life insurance, and the other funds the investment account.

The earnings on the investment account accrue to your benefit. As you age and the cost of the term coverage increases, the insurance company sets aside a progressively larger portion of your premium to cover that cost, until eventually the term insurance cost exceeds the premium.

At that point, the investment account funds the shortfall in the premium payments. The “cash value” of the policy basically represents the balance of the investment account. Ordinarily, you can terminate the policy at any time and get paid your policy’s cash value.[pullquote]The federal tax code provides a massive tax break for holders of permanent life insurance and annuity policies.[/pullquote]

Annuity policies operate conceptually much like life insurance policies, except they insure the risk of long life, as opposed to the risk of premature death. Like a permanent insurance policy, an annuity policy combines a pure insurance policy and an investment account invested for the benefit of the policyholder.

If the federal government taxed a permanent insurance or annuity policy on its substance, policyholders would face a tax on the earnings on the investment account portion of their policies, just as they would if they purchased term insurance and managed their own investment account.

But the federal tax code provides a massive tax break for holders of permanent life insurance and annuity policies. The earnings these policies generate face no tax. And if policyholders cash their policies in, they get to subtract — for tax purposes — all the dollars they paid in premiums from the cash surrender value of their policies.

In other words, policyholders can avoid tax on the portion of their investment earnings that went to fund the cost of their life insurance or annuity protection.

From the standpoint of tax policy, the preferential treatment of permanent life insurance and annuity policies has no justification. This treatment blatantly elevates form over substance and amounts to one of the largest giveaways in the tax code.

Policyholders actually pay for this massive tax break. They pay their insurance companies. At the outset of any permanent life or annuity policy, policyholders must pass a sizeable fee to their insurance company out of the cash surrender value of their policy.[pullquote]The insurance industry gets to share in the value of the federal tax giveaway that goes to wealthy policyholders.[/pullquote]

The tax benefits that permanent life and annuities provide typically take about ten years to offset the cost of this insurance company fee. Insurance companies also often charge more for the insurance protection component of the policy than would be the cost for pure term insurance.

In effect, the insurance industry gets to share in the value of the federal tax giveaway that goes to policyholders.

How much does this giveaway cost taxpayers overall? According to a Citizens for Tax Justice report, the revenue loss from the deferral of tax on the inside buildup of life insurance policies and annuities runs $270 billion over ten years.

We don’t currently have specific data on the size of the pool of wealth held in permanent life insurance policies and annuities. But we do know from Federal Reserve Board data that the wealthier a taxpayer, the more likely that taxpayer will own a permanent life policy and the greater the cash value of that policy will be.

In 2010, the Fed data show, only 24.1 percent of households in the third quartile of American households — the 25 percent of households that held a net worth right above the national household average — owned a cash value life insurance policy. These households held an average cash value of $17,100 in their policies.

Up in the top 10 percent of American households, by contrast, 36.8 percent held permanent life policies, and these policies averaged $82,700 in value.

Most middle class taxpayers face a top marginal tax rate of just 15 percent. At this rate, the life insurance tax preference doesn’t generate much in the way of tax savings. The lion’s share of the $270 billion tax break from the preferential treatment of permanent life and annuity policies is clearly flowing to taxpayers at America’s income summit.

But not just these wealthy taxpayers. Our tax system, remember, designates the insurance industry as the gatekeeper to the favorable tax treatment of permanent life and annuities and allows insurance companies to charge admission.[pullquote]Most of the $270 billion tax break from the preferential treatment of permanent life and annuity policies is flowing to taxpayers at America’s income summit.[/pullquote]

The bottom line: The federal government will be forfeiting $270 billion in tax revenue over the next ten years to perpetuate an indirect subsidy to the insurance industry and enhance the net worth of wealthy Americans.

How does the size of this giveaway to the wealthy and subsidy to the insurance industry compare to the size of the reduction in Social Security benefits now getting debated in Congress?

The key Social Security change before lawmakers, a switch to the “chained CPI,” will wind up cutting the Social Security benefits average Americans receive by $127.2 billion over ten years, according to the Congressional Budget Office.

Other Americans also receive federal benefits that would be reduced under a switch to a chained CPI approach to calculating inflation. Adding these Americans into the mix would up the total benefit cut to $216 billion over ten years.

In other words, perpetuating the tax break for permanent life and annuity policies will cost more over the next ten years than would the cost of retaining the current cost-of-living adjustment for recipients of Social Security and other federal benefits.

A generation ago, lawmakers considered eliminating the massive tax break for permanent life and annuity policies to fund a cut in income tax rates under the 1986 Tax Act. But intense lobbying by the insurance industry squashed that move.

Today, some 27 years later, Congress is considering whether to slash Social Security benefits, and lawmakers aren’t even considering the elimination of the life insurance and annuity tax break — for our wealthiest — as an alternative.

The first article in this series: Retirement Vehicle or Giveaway to the Rich?

Bob Lord, a veteran tax lawyer and former congressional candidate, practices and blogs in Phoenix, Arizona.