Single-Premium Life Insurance

Single-premium life insurance is a type of life insurance that charges the policyholder a single up-front premium payment to fully fund the policy. It was once a popular tax shelter.

Single-premium life insurance requires a large sum of money from the policyholder that puts this type of insurance out of reach of many applicants. The great advantage to single-premium life insurance is that the single payment fully funds the policy, immediately guaranteeing a sizable death benefit to the beneficiaries.

Another useful feature of some single-premium life insurance policies is their ability to finance long-term care, should the insured require it. Some single-premium life insurance policies allow policyholders to draw from the death benefit tax-free to pay living expenses. Such withdrawals decrease the amount of the death benefit accordingly.

Two popular single-premium policies are single-premium whole life and single-premium variable life. The two differ in how each policy accumulates a cash value. The first offers a risk-free fixed interest rate. The second invests cash value in actively managed portfolios and comes with the risks and potential rewards of active investing.

The U.S. Congress passed the Tax Reform Act of 1986 ostensibly to simplify the income-tax code and close loopholes. One loophole still open was single-premium life insurance, which quickly became popular as tax shelter.

Many life-insurance policies offer tax advantages, but single-premium life insurance policies were particularly advantageous. First, the single premium payment allows the policyholder to dump a huge sum of cash into the policy at once. Second, many single-premium policies offered “wash loans” — loans against policies’ cash values that come effectively interest- and tax-free, the interest rate on the cash value canceling out the interest on the loans.

Congress passed the Technical and Miscellaneous Revenue Act of 1988 to discourage the use of life-insurance policies as tax shelters. The act reclassified single-premium life insurance policies as modified endowment contracts (MEC). MECs grant loans and dispense withdrawal on a last-in-first-out (LIFO) basis. That means taxable gains come out of the policy before the tax-free return of principle, thus reducing their usefulness as tax shelters.

The introduction of the MEC prompted people to turn to whole life insurance policies for their tax benefits. While all single-premium life insurance policies are MECs, whole life policies only become MECs if they exceed premium limits. Investors looking to use whole life policies as tax shelters attempt to wring the maximum tax advantage of the policy without crossing into MEC territory.