Best Way to Pay for Life Insurance - Part 2

The proposal to tax the inside buildup went on to explain that even if the policy owner did surrender the policy during his or her lifetime and therefore incurred ordinary income tax on the amount of policy value received in excess of the policy owner's investment, that policy owner still has reaped a substantial income tax benefit. This is because the tax basis in the policy "includes the portion of his premium that had been used to pay the cost of life insurance for past periods." Consequently, the income to be taxed is reduced by the cost of the life insurance, even though this cost is a personal expense and would not be deductible if paid directly. The cost of life insurance has become equivalent to a tax deductible expense in these policies.

The proposal argued in favor of taxation of the inside buildup of life insurance for a number of other reasons.

1. The deregulation of financial institutions, along with various economic factors, has resulted in an increase in the rate of interest and investment return paid on investments within insurance policies.

2. The investment orientation of cash-value life insurance products is increasing.

3. The favorable tax treatment of the inside buildup in an insurance policy can be obtained through a contract that provides relatively small amounts of pure insurance coverage. Note: The proposal refers to pure insurance, which also is often referred to as net amount at risk, which we are defining as life insurance.

4. Comparable investment products generally are not tax­free or tax-deferred.

5. Life insurance is not subject to significant limitations on the timing and amount of contributions. (Contributions were subsequently subject to greater limitations under the tax law passed in 1988 - "Modified Endowment Insurance")

6. The tax-favored treatment of the buildup within an insurance policy goes in distorted fashion more to the wealthy than to the not so wealthy.