Vol 7 No 5		October 2005

Katt & Company is a national fee-only life insurance advising firm. The June 2002 Forbes magazine, and a July 16, 2003 Wall Street Journal article, name Peter Katt as one of only four nationally recognized advisors. The Forbes article states that, "…advisers are well worth the money… These savants are working for no one but you…" For references please contact us.

Return of Premium Term Insurance

"The issue of taxes does not come up. . . buyers are under the impression that the basis in the contract is equal to the sum of all premiums paid. . . no tax liability is expected . . . In reality, the picture is much less clear. There is no definitive case law that exists that defines whether or not premiums paid into a term contract constitute basis."

Some insurance companies are finding traction in the marketplace with so-called return of premium term insurance. This policy guarantees that should a buyer live beyond the end of the coverage (typically 15 or 20 years), he will then receive the sum of all premiums paid during the coverage period.

In our experience, the issue of taxes does not come up at the time of purchase, and we believe that most agents and buyers are under the impression that the basis in the contract is equal to the sum of all premiums paid - and therefore when those premiums are returned at the end of the coverage period, no tax liability is expected to be incurred.

In reality, the picture is much less clear. There is no definitive case law that exists that defines whether or not premiums paid into a term contract constitute basis. It is conceivable that the IRS would take the position that the basis of each year's premium was "used up" by the coverage provided. In fact, some insurance companies (of course not the ones selling this product) currently take this conservative position and report a zero basis for term contracts.

Is the return of premium feature worthwhile? Dr. G is a 60-year-old male interested in 15-year term coverage of $500,000. He is choosing between a term policy without the return of premium rider ($4,645) and the same policy with the rider ($14,100).

Dr. G has roughly an 85% chance of surviving to the end of the 15-year period. If he just purchases regular term, there is an 85% chance that he will end up with nothing. But if he adds the return of premium rider, he will get all of his premiums back.

The premium return in 15 years is $211,500. Taking into account the value of the term coverage, measured at $4,645 a year, this provides a tax-free yield of 4.85%. But if the premium return of $211,500 is recognized as income (40% marginal combined tax rates) the net is only $126,900 and produces a negative yield of [1.4%].

I doubt the insurance companies marketing return of premium term intend to send out 1099s notifying the IRS that the recipient must recognize it as income. It may be that this will turn out to be a financial transaction that leaves no telltale trail that would alert the IRS to look into it. In that case the premium refunds will be tax-free and provide, in the current interest rate environment, a decent rate of return. But clients should be alerted to the possibility of a different outcome prior to buying return of premium term policies.