Guideline Premium Test and Cash Value Accumulation Test
The guideline premium test and the cash value accumulation test offer an IRS approved way of determining whether or not a life insurance policy qualifies for special income tax treatment as such. The guideline premium test requires a minimum corridor of "at risk" death benefit that exceeds the cash value. This corridor shrinks as a percentage of the total death benefit as the attained age of the insured increases, and can be zero by the time the insured attains age 95. Thus, the amount of premiums that are able to be paid during the life of the policy is limited, since premiums generate cash values.
The cash value accumulation test does not limit premiums, but it forces an amount of "at risk" death benefit that will not decrease over time. As the insured gets older, the cost of insurance (COI) will increase greatly. This COI may tend to drag down overall performance of a CVAT policy. In the long run, the GPT makes using IUL as a cash repository better than CVAT when competing with banks.
The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 provided a statutory definition of life insurance for flexible premium (i.e., Universal Life) products that limited the amount of premium per dollar of death benefit and required at least a minimum amount of "at risk" coverage in order to be treated as life insurance for income tax purposes (i.e., income-tax-free death benefits, and cash value gains not currently taxed). In addition, for life insurance that is not deemed to be a Modified Endowment Contract, policy loans not treated as taxable distributions.
TEFRA was later modified by the Deficit Reduction Act (DEFRA) of 1984 to expand this general set of qualifications to apply to all policy contracts and included mathematical calculations for ongoing testing. Together IRC Sec. 7702(a) provides that, for a contract to qualify as a life insurance contract for Federal income tax purposes, the contract must be a life insurance contract under the applicable law and must either (1) satisfy the cash value accumulation test of § 7702(b), or (2) both meet the guideline premium requirements of § 7702(c) and fall within the cash value corridor of § 7702(d).
A contract meets the guideline premium requirements of § 7702(c) if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time. The guideline premium limitation as of any date is the greater of (A) the guideline single premium, or (B) the sum of the guideline level premiums to that date. The Guideline Single Premium (GSP) is the premium that would be required on the date the contract is issued to fund the future benefits under the contract, based on the following three elements enumerated in section 7702(c)(3)(B): (i) reasonable mortality charges that meet the requirements (if any) prescribed in regulations and that (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners' standard tables (as defined in section 807(d)(5)) as of the time the contract is issued; (ii) any reasonable charges (other than mortality charges) that (on the basis of the company's experience, if any, with respect to similar contracts) are reasonably expected to be actually paid; and (iii) interest at the greater of an annual effective rate of six percent or the rate or rates guaranteed on issuance of the contract. The Guideline Level Premium (GLP) is the level annual amount (calculated as described in the definition of Initial Guideline Single Premium above), payable over a period not ending before the insured attains age 95, computed on the same basis but using a minimum interest rate of four percent, rather than six percent. (Back to IUL Table of Contents)