# 111. **FISCAL INCENTIVES**

# **a. General** Tax **Principles**

Life insurance and annuities sold both to individuals and to employers in the United States are greatly influenced by the tax treatment accorded such products under federal laws. It should be understood that the tax system applied to U.S. insurance policies may differ widely from that of other advanced nations, with the result that the relative attraction of a given product or contract in one country may not apply to a similar policy sold under another tax system.

Fiscal incentives for insurance products under U.S. laws and regulations are designed to serve well-recognized social and economic functions. To quote from a recent tax study by the U.S. Treasury Department: The principal justifications for the current tax treatment of life insurance and annuity products are to encourage the provision of financial support of dependents after the death of a wage earner, to allow protection against outliving one's assets, and to encourage private long-term savings'.

In practice, the taxability of insurance products varies widely according to the nature of the product, whether it is purchased by individuals as life insurance or an annuity or by business firms as part of an employee pension plan. There are three basic issues of taxability in connection with insurance products. The first is concerned with whether investment earnings arising from such products should be exempt from tax, or taxed at some deferred time, or subject to immediate income tax along with other forms of income. A second tax issue applies to pensions and retirement savings plans, as to whether contributions to such plans may be deducted from taxable income, either by the employee or the employer. The third tax issue is whether federal estate taxes (as distinct from income taxes) are levied on proceeds from life insurance and from survivorship annuities.

# **b.** Products Sold to Individuals as Insurance or Annuities

Death benefits from a life insurance policy are not subject to income taxes upon receipt by the policy beneficiaries. For this reason, investment income earned on most life insurance policies held until death is, in effect, exempt from federal income taxes. Under whole-life policies, where the interest earned on the accumulated reserves is built up over many years, the amount of investment earnings used to pay eventual death claims is considerable. But such earnings, known as "the inside buildup," escape payment of income tax entirely under U.S. law. Such treatment is in contrast to the taxability of current earnings on many other forms of long-term savings by individuals, e.g., corporate bonds or stocks, bank certificates of deposit, or U.S. Treasury bonds. Hence, saving through cash-value life insurance is often described as "tax advantaged".

Cash-value or permanent life insurance also has a clear tax advantage over term life. If an individual chooses to purchase term life, with a lower premium than cash value life, he could invest the difference each year in marketable securities, for example, and possibly earn more than the insurance I Department of the Treasury, Report to the Congress on the Taxation of Life Insurance Company Products, March 1990.

**10**