T1-L2-P21

The IRS Corridor of Risk

In the early days, Universal life offered a great opportunity for tax avoidance with only the insured's:

• amount at risk at his/her attained age
  
  
• being charged to the policy monthly

Picture this scenario: It is 1981; Mr. Gotrocks buys a $1,100,000 Universal life policy on his grandson who is 12 years old.

• He rolls into the policy $1,000,000 from a taxable source.
  
  
• The amount at risk is only $100,000 on a 12 year old. The monthly mortality charge to the policy is at best $5 or $6.
  
  
• In those days, it was not uncommon for universal life contracts to be paying competitive rates as high as 10-12% interest.
  
  
• IRS also had tax rates as high as 50%.
  
  
• At 12%, Mr. Gotrocks made $120,000 in tax-free interest at a cost of maybe $100 for insurance and loading. He withdrew $120,000 of principal tax-free (FIFO- "first in first out").

Eventually IRS made some new rules.

1. Any policy on an individual age 40 or under must have 150% of the cash value at risk. Mr. Gotrocks would have to buy a $2,500,000 policy with his $1,000,000, thereby paying for $1,500,000 of insurance at risk monthly rather than $100,000.
   
   
2. No policy can endow prior to age 95 and have the policy enjoy the cash value tax advantages. Therefore, some premium for an amount at risk must be charged to the contract every month, all the way to age 95.
   
   
3. This means that the mandated 150% "at risk" corridor at age 40 is diminishing to 0% at age 95.
   
   
4. NOTE: This ruling eliminated the tax advantages of the traditional endowment policies and led to their demise.
   
   
5. Withdrawals were changed to LIFO (last in first out) and therefore taxed as ordinary income.

As cash values rise, the insurer will increase the death benefit to keep the corridor within limits to avoid the loss of the tax advantages in the buildup of the policy's reserve.

The reason for the IRS Corridor of Risk is to discourage using insurance as a tax dodge rather than its intended purpose.