Certain types of life insurance policies and annuities combine features of insurance and tax-favored savings accounts. (An annuity is a contract with an insurance company under which, in exchange for premiums, the company agrees to make fixed or variable payments to a person at a future time, usually during retirement.) Portions of the premiums paid for certain types of insurance policies, such as whole-life polices, and for annuities are invested and earn interest, dividends, and other types of investment income. (A whole-life policy is a contract with an insurance company that provides life insurance coverage throughout the policyholder's lifetime--not just for a specified period, as is the case with term life insurance.) That investment income, sometimes called inside buildup, is generally not included in taxable income until it is paid out to the policyholder as a return of cash value or as a recurring payment. If the inside buildup is used to reduce premiums in later years (as occurs with whole-life policies) or is paid out because of the death of the insured, it can escape taxation under the income tax.
Under this option, life insurance companies would inform policyholders annually of the investment income their accounts have realized, just as mutual funds do now, and policyholders would include those amounts in their taxable income for that year. In turn, the cash value from life insurance policies and recurring payments from annuities would not be taxed when they were paid out. That approach would make the tax treatment of investment income from life insurance and annuities match the treatment of income from bank accounts, taxable bonds, or mutual funds. (Taxes on investment income from annuities purchased as part of a qualified pension plan or qualified individual retirement account would still be deferred until benefits were paid.) Such changes in tax treatment would increase revenues by $117 billion from 2012 through 2016 and by $260 billion from 2012 through 2021. Those revenue gains would diminish over time, however, relative to the size of the economy, because taxes paid on the inside buildup would mean that future payouts were tax-exempt.
By taxing the investment income from life insurance and annuities as it was realized, this option would eliminate a tax incentive to purchase such insurance products. Whether that outcome would be a benefit or a drawback depends on whether the current incentive is considered beneficial. Encouraging the purchase of life insurance is useful if people buy too little because they underestimate the financial hardship that their death will impose on their families. Encouraging the purchase of annuities is helpful if people tend to underestimate their retirement spending or life span and thus buy too little annuity insurance to protect against outliving their assets. However, scant evidence exists about how successful the current tax treatment is in encouraging people to obtain adequate amounts of insurance.
If providing an incentive to purchase life insurance is indeed considered a useful part of the tax system, an alternative approach would be to encourage such purchases directly by giving people a tax credit for their life insurance premiums or by allowing them to deduct part of those premiums from their taxable income. Either alternative would encourage people to purchase term insurance as well as whole-life policies. (Term insurance, which accounts for a large proportion of all life insurance policies, earns no inside buildup and so does not benefit from the same favorable tax treatment. Term insurance provides coverage for a specified period and pays benefits only if the policyholder dies during the term. Otherwise, the policy expires without value.)
A disadvantage of taxing inside buildup is that the people who would be affected would not have access to the buildup to pay the tax. People who had accumulated considerable savings from contributions to whole-life policies or annuities could owe substantial amounts of is currently taxed in a manner that is similar to the treat- taxes relative to the cash income from which they would ment of capital gains, in that the gains are not taxed until have to pay the taxes. (That is one reason inside buildup the investor sells the asset.) RELATED OPTIONS: Revenues, Options 11 and 12