Life Insurance Definition - Part 1

Section 7702 of the Deficit Reduction Act of 1984 (DEFRA) defines life insurance.

Section 7702 of the Deficit Reduction Act of 1984 (DEFRA) defines life insurance for income tax purposes in terms of requiring an "amount at risk." In other words, if the insured dies, the law stipulates that to enjoy all the income tax benefits of a life insurance policy, a significant amount of insurance company money must be paid out to the beneficiary.

If the policy fails this test of adequate amount at risk-then it is not considered a life insurance policy and all income tax benefits are eliminated. As you review the following tests that are required by the tax laws to determine whether a contract qualifies as life insurance or not, keep in mind why Uncle Sam is so concerned. Uncle Sam knows and appreciates the income tax benefits of life insurance and creates these rules to limit how much money you can put into a policy.

The inside buildup, meaning the compounding that goes on inside the policy on your capital, occurs without taxation, giving you tax-free compounding. Life insurance proceeds are paid at death without being subject to income tax, meaning your lifetime of compounding and the amount at risk escape income taxation entirely at death. In variable policies, you can choose among the investment alternatives offered within your policy and then change your mind and choose to use others without incurring income taxation or additional expenses.

You can use investment strategies such as dollar cost averaging, asset allocation, and re­balancing, all without income taxation or additional expenses. You also can access the money in your policy by policy loan, and some­times withdrawal, if you treat the policy properly, again without income taxes. It is not surprising that the federal government wants to limit how much you can put into such a contract.