Understanding Variable Insurance Policies
Variable insurance products were developed by insurance companies primarily to meet competition from mutual fund type investments. If nothing else, the insurance industry is very creative and extraordinarily competitive. Essentially, variable life insurance is a whole life insurance policy, which allows the policy owner to direct the investment of the cash values within a selection of pre-set investment vehicles. These are usually mutual funds operated by the insurance company.
Most variable life policies allow policy owners to switch their investments in the underlying funds several times a year. Generally, there is no charge for the transfer of funds between the underlying investments, and the transfers are tax-free. The income earned by these investments underlying the policies' cash values may be accumulated tax-free or on a tax-deferred basis. The tax treatment depends on whether or not the gains are distributed during the policy owner's life or are funded at death.
Many professional planners and business advisors recognize that variable life insurance and, in particular, variable universal life insurance are important in solving business problems. The attractive features of these policies include their flexibility, their growth of cash values and the resulting death benefits. When used as a non-qualified deferred compensation plan, for example, a variable policy can potentially provide higher tax deferred cash value accumulations than a traditional whole life policy or even a universal life policy.
Variable policies also have variable tax consequences. With a variable insurance product, capital appreciation loses its character as capital gain. Where there are distributions because of a withdrawal or a surrender of the policy, the amount received becomes taxable as ordinary income. While the maximum or marginal tax rate is 39.6%, it is well known that the effective rate can be much higher due to certain computational complexities within the operations of the Internal Revenue Code. However, if the policy is not drawn down, the increase in value will clearly increase the available death benefit, which can be structured to be received by the beneficiaries free of any income or estate tax.
