Include Investment Income From Life Insurance and Annuities in Taxable Income

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues 13 24 21 20 21 21 22 22 23 23 99 210

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014.

Certain types of life insurance policies and annuities combine features of insurance and tax-favored savings accounts. (An annuity is a contract with an insurance company under which, in exchange for premiums, the company agrees to make fixed or variable payments to a person at a future time, usually during retirement.) Portions of the premiums paid for certain types of insurance policies, such as whole-life polices, and for annuities are invested and earn interest, dividends, and other types of investment income. (A whole-life policy is a contract with an insurance company that provides life insurance coverage throughout the policyholder’s lifetime—not just for a specified period, as is the case with term life insurance.) That investment income, sometimes called inside buildup, is generally not included in taxable income until it is paid out to the policyholder as a return of cash value or as a recurring payment. If the inside buildup is used to reduce premiums in later years (as occurs with whole-life policies) or is paid out because of the death of the insured, it can escape taxation under the income tax.

Under this option, life insurance companies would inform policyholders annually of the investment income their accounts have realized, just as mutual funds do now, and policyholders would include those amounts in their taxable income for that year. In turn, the cash value from life insurance policies and recurring payments from annuities would be taxable only to the extent that accrued capital gains had not already been taxed. This approach would make the tax treatment of investment income from life insurance and annuities match the treatment of income from bank accounts, taxable bonds, or mutual funds. (Taxes on investment income from annuities purchased as part of a qualified pension plan or qualified individual retirement account would still be deferred until benefits were paid.) Such changes in tax treatment would increase revenues by $210 billion from 2014 through 2023, the staff of the Joint Committee on Taxation estimates. Those revenue gains would diminish over time, however, relative to the size of the economy, because taxes paid on the inside buildup would lower taxes paid on future payouts.

An advantage of the option is that people would be less likely to base decisions about the purchase of whole life insurance and annuities on tax considerations. Investment income from whole life insurance and annuities would be taxed as it was realized, just as income from bank accounts, mutual funds, and many other types of financial instruments is taxed. The option would tax whole life insurance and term life insurance in the same way. Because term insurance provides coverage for a specified period and pays benefits only if the policyholder dies during the term, it generates no inside buildup and, hence, does not offer the tax advantage that whole-life insurance does under current law. By eliminating the tax advantages associated with whole life insurance and annuities, when compared with those provided by other forms of investment, the option would encourage people to focus on how much life insurance and annuity income they need—rather than on the expected tax savings—when purchasing those products.

As a result, the change would reduce people’s incentive to purchase life insurance and annuities. Without that incentive, however, people might buy too little insurance if they underestimate the financial hardship that their death would impose on their families. They might also underestimate their retirement spending or life span and, thus, buy too little annuity insurance to protect against outliving their assets. However, little evidence exists about how successful the current tax treatment is in encouraging people to obtain adequate amounts of insurance.

If providing an incentive to purchase life insurance is, indeed, considered a useful part of the tax system, an alternative approach would be to encourage such purchases directly by giving people a tax credit for their life insurance premiums or by allowing them to deduct part of those premiums from their taxable income. Either approach would encourage people to purchase term insurance as well as whole-life policies.

Another disadvantage of taxing inside buildup is that the people who would be affected by the change would not have access to the buildup to pay the tax. People who had accumulated considerable savings from contributions to whole-life policies or annuities could owe substantial amounts of taxes relative to the cash income from which they would have to pay the taxes.