I've recently come across several IUL illustrations proposed using the "IRA Rescue" strategy that are funded as either a 3-pay or 5-pay. I have a lot of problems with this type of policy design, but this one is particularly worrisome to me. In fact, there are only one or two carriers that will allow this to happen in their illustrations. I'm going to use Minnesota Life in this example.
These "IRA Rescue" designs use a 3 pay or 5 pay as I said earlier, typically with the client liquidating the IRA or other "tax hostile" plan over the 3 or 5 year schedules to fund an IUL policy which then generates "tax free income" for the rest of the client's life instead of taking taxable distributions from a qualified plan.
In order to avoid a TAMRA violation which would classify the policy as a MEC, these policies have an extremely high initial death benefit. Because the death benefit is so high, the net amount at risk is also exceptionally high, leading to much a higher cost of insurance. In this strategy, the policies are illustrated starting with an increasing death benefit option and then switching to a level death benefit option in the year following the final premium payment.
In the year following the switch in death benefit options, the face amount is drastically reduced in order to reduce the net amount at risk. In the attached example, the death benefit drops from $3,148,438 to $763,013 in the 5th contract year. This is where the problems start. Internal Revenue Code Section 7702A states the following in reference to a reduction in benefits and the 7 pay test:
This would make one assume that because these contracts have a (significant) reduction in benefits in the first seven contract years, that the 7 pay test would be reapplied with the new, reduced death benefit, and the 3 or 5 premiums already paid, thus the policy would be a MEC.
How do they get around this? Well, they use section 7702A's "material change" rule:
In these policy designs, the switch from an increasing death benefit option to a level death benefit option is treated as a material change. Because of this material change treatment, the contract is treated as newly issued. Because it is newly issued, they lower the death benefit to the minimum amount within the cash value corridor, and reapply the 7 pay test to this new contract, which has had exactly $0.00 of premium in the prior 7 years, thus they do not classify it as a MEC.
My question: is there any precedent for treating the switch from increasing to level death benefit as a material change? It seems to be pretty hard to argue that a mere switch in death benefit is an "increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract," especially considering the fact that the policy was designed to have such a switch take place prior to issue.
I find the treatment of a switch in death benefit options as a material change to be questionable, at best. What are your thoughts on this matter? Is this a time-bomb of liability waiting to explode? Is there legitimate precedence or justification for treating the switch as a material change? I don't see how an agent or client could reasonably argue that their initial need for over $3,000,000 in death benefit protection suddenly changed to $763,013, especially when this change is illustrated prior to the policy's issue.
There are MANY reasons I'm not a fan of the "IRA Rescue" strategy they use, but this one stands out amongst the rest. Thank you in advance for any input!
These "IRA Rescue" designs use a 3 pay or 5 pay as I said earlier, typically with the client liquidating the IRA or other "tax hostile" plan over the 3 or 5 year schedules to fund an IUL policy which then generates "tax free income" for the rest of the client's life instead of taking taxable distributions from a qualified plan.
In order to avoid a TAMRA violation which would classify the policy as a MEC, these policies have an extremely high initial death benefit. Because the death benefit is so high, the net amount at risk is also exceptionally high, leading to much a higher cost of insurance. In this strategy, the policies are illustrated starting with an increasing death benefit option and then switching to a level death benefit option in the year following the final premium payment.
In the year following the switch in death benefit options, the face amount is drastically reduced in order to reduce the net amount at risk. In the attached example, the death benefit drops from $3,148,438 to $763,013 in the 5th contract year. This is where the problems start. Internal Revenue Code Section 7702A states the following in reference to a reduction in benefits and the 7 pay test:
(2) Reduction in benefits during 1st 7 years
(A) In generalIf there is a reduction in benefits under the contract within the 1st 7 contract years, this section shall be applied as if the contract had originally been issued at the reduced benefit level.
This would make one assume that because these contracts have a (significant) reduction in benefits in the first seven contract years, that the 7 pay test would be reapplied with the new, reduced death benefit, and the 3 or 5 premiums already paid, thus the policy would be a MEC.
How do they get around this? Well, they use section 7702A's "material change" rule:
(3) Treatment of material changes
(A) In general If there is a material change in the benefits under (or in other terms of) the contract which was not reflected in any previous determination under this section, for purposes of this section—
(i) such contract shall be treated as a new contract entered into on the day on which such material change takes effect, and
(ii) appropriate adjustments shall be made in determining whether such contract meets the 7-pay test of subsection (b) to take into account the cash surrender value under the contract.
(B) Treatment of certain benefit increases For purposes of subparagraph (A), the term “material change” includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract. Such term shall not include—
(i) any increase which is attributable to the payment of premiums necessary to fund the lowest level of the death benefit and qualified additional benefits payable in the 1st 7 contract years (determined after taking into account death benefit increases described in subparagraph (A) or (B) of section 7702(e)(2)) or to crediting of interest or other earnings (including policyholder dividends) in respect of such premiums, and
(ii) to the extent provided in regulations, any cost-of-living increase based on an established broad-based index if such increase is funded ratably over the remaining period during which premiums are required to be paid under the contract.
In these policy designs, the switch from an increasing death benefit option to a level death benefit option is treated as a material change. Because of this material change treatment, the contract is treated as newly issued. Because it is newly issued, they lower the death benefit to the minimum amount within the cash value corridor, and reapply the 7 pay test to this new contract, which has had exactly $0.00 of premium in the prior 7 years, thus they do not classify it as a MEC.
My question: is there any precedent for treating the switch from increasing to level death benefit as a material change? It seems to be pretty hard to argue that a mere switch in death benefit is an "increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract," especially considering the fact that the policy was designed to have such a switch take place prior to issue.
I find the treatment of a switch in death benefit options as a material change to be questionable, at best. What are your thoughts on this matter? Is this a time-bomb of liability waiting to explode? Is there legitimate precedence or justification for treating the switch as a material change? I don't see how an agent or client could reasonably argue that their initial need for over $3,000,000 in death benefit protection suddenly changed to $763,013, especially when this change is illustrated prior to the policy's issue.
There are MANY reasons I'm not a fan of the "IRA Rescue" strategy they use, but this one stands out amongst the rest. Thank you in advance for any input!
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