Legislative Risk and Life Insurance: Are There Red Flags Ahead?

As CJ Cregg, fictional White House Press Secretary on the hit TV show West Wing, once said: “Everybody’s stupid in an election year.”

In an election year, all sorts of proposals get thrown around. All kinds of bills are introduced. And all manner of predictions start to make waves. 

We’re all trying to handicap the types of proposals that may influence the election and - of equal importance - the types of proposals that might result from a given election outcome.

I broadly view this handicapping as an attempt to assess Legislative Risk, and it’s an important topic for American savers to understand.

When it comes to retirement assets, many savers are at risk of Congress making changes to popular savings vehicles like 401(k)s, IRAs, and Roth accounts. These changes could be around the accounts themselves or more likely around the level of taxation Americans experience when contributing or withdrawing income from these accounts.

If Congress changes the structure or level of taxation on retirement assets, savers could find themselves sending more of their funds to the IRS in taxes and being left with far less of their funds to spend as income. 

But the title of this article is Legislative Risk and Life Insurance. So what Congressional action are we watching for when it comes to cash value life insurance, like IUL, that savers use for retirement income?

Think Advisor this week reported on the S&P Global Insurance Hot Topics Conference in New York. One of the panelists evaluated the likelihood of Congress trying to tax the cash value build-up inside life insurance policies. 

The discussion highlights one of the biggest benefits IUL can bring to a client’s retirement approach: contractual protection.

Retirement accounts like IRAs and 401(k)s - and even their Roth counterparts - are just that: accounts. 

When Congress passes new laws impacting accounts, those laws take immediate effect on both accounts established going forward AND accounts already in existence today. 

So, the contribution, distribution, and tax rules can constantly change for IRAs and Roth IRAs.

This means the legislative risk surrounding retirement accounts is high: Congress can change the rules, and those rules impact everyone with one of those accounts.

But IUL is different. That’s because IUL - like all life insurance - is not an account. It’s a contract. 

Contracts have a very different legislative risk profile. 

The courts have generally upheld that when Congress changes the rules on a contract, those rules can be applied to new contracts going forward but can NOT be applied retroactively to contracts already in place. 

We saw this play out in the 1980s and 1990s with Congressional reforms like TAMRA and TEFRA. Legislation made adjustments to the tax status of certain cash value life insurance policies, but only for policies going forward. The policies already in place continued to operate under the old rules. (For example, a pre-TEFRA life insurance policy could be a MEC, but not incur any of the tax requirements the bill established for MEC policies going forward.)

This one small difference can have a big impact on your client’s retirement assets in a rising tax environment.

I often get asked by advisors and savers alike if I think Congress will change the tax-free nature of life insurance. 

And I have two answers:

1. Probably not, as it’s in the government’s best interest to incentivize private death benefits that relieve pressure on government programs, like Medicaid and food stamps, that people without adequate assets would rely on in old age.

2. It doesn’t matter, as we’re helping our clients today establish contracts that can’t be changed by Congress. 

The S&P Global panelist was right: Congress is unlikely to take a serious pass at taxing life insurance values simply because it’s hard to generate enough revenue when you can only tax policies going forward. 

It is much more likely that Congress is focusing its attention on IRAs and 401(k)s for higher-net-worth savers and savers with larger account balances since any changes they make to those accounts take immediate effect on the billions of dollars currently housed in tax-deferred vehicles. 

It’s up to us as advisors to help educate and protect our clients from the legislative whims of Washington. 

After all, as West Wing’s fictional President Jed Bartlet said, “Never doubt that a small group of thoughtful individuals can change the world.”

Want to learn more? 

I’ll be digging into the benefits of contracts during Stonewood Financial’s upcoming Innovate Summit conference February 29-March 1. 

(I’ll also be discussing legislative changes we can expect from Washington, what the election could mean for US savers, and how to incorporate tax risk both into your income planning and estate planning efforts in 2024.) 

If you’ve never attended an Innovate conference before, schedule a quick call with my team and we’ll see if you qualify to waive the $599 registration fee so you can attend for free.