This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at the tax exclusion for investment income of life insurance contracts, commonly known as life insurance “inside buildup.” This tax subsidy for life insurance is expected to cost the federal government $129 billion between 2012 and 2016.
What is the tax exclusion of inside buildup?
The tax code favors life insurance by excluding death benefits from taxation and by permitting life insurance premiums to be invested on a tax-free basis. The latter tax benefit is called tax-free inside buildup. It is of particular value for the holders of permanent life insurance policies such as “whole life” or “universal life” policies.
There are two basic kinds of life insurance. If a person buys a “term” life insurance policy, the insurance company agrees to pay a defined amount if the insured dies within a certain time period, typically a year. The policyholder pays a premium to cover himself for that term. If the insured lives through the term, the policy simply expires and will have to be renewed.
Permanent life insurance policies are not based on a limited term. In a “whole” life insurance policy, for example, the insured agrees to pay a fixed premium that does not change over his lifetime. In exchange, the insurance company agrees to pay a benefit when he dies. As the policyholder continues to pay premiums and gets older, the value of the insurance contract increases. This is reflected in the increasing redemption value of the contract for those older policyholders who elect to “cash out” before they die.
Because they grow in value, these types of policies can serve as savings vehicles.
How does inside buildup work?
Insurance companies invest their policyholders’ premiums. The returns on those investments help the insurance company pay both death benefits and redeem “cashed out” policies. Death benefits are not considered income to beneficiaries for tax purposes. That is, beneficiaries don’t pay taxes on the investment appreciation that the benefit represents.
If the insured cashes out a policy during his lifetime, he’s taxed only on the investment gains; the investment returns are therefore not tax-free, but they are tax-deferred. 
Why is this a tax expenditure?
A tax expenditure is a government spending or subsidy program that happens to be administered through the tax code. Technically, tax expenditures are special tax rules that favor certain activities or taxpayers and result in a cost to the federal treasury through a loss of tax revenue. The exclusion of investment income in life insurance policies from taxation is a tax expenditure because investment income (outside of tax-favored retirement accounts) is generally subject to tax as it is earned.
How much does it cost?
The nontaxation of life insurance inside buildup will cost $22.6 billion in fiscal year 2012, and a combined $129 billion over 2012-2016.
Why subsidize life insurance through the tax code?
Life insurance receives favorable tax treatment principally because of the belief that public policy should encourage families to protect themselves financially from the unexpected loss of a provider.
Death benefits have always been excluded from taxation. The inside buildup of life insurance has gone untaxed also because of the difficulty in taxing people from year to year on investment gains within life insurance policies that aren’t realized in cash. (Though one alternative is to tax the insurance company on the gains as they are earned rather than policyholders.) 
Who benefits from this tax preference?
“The exemption of inside build-up distorts investors’ decisions by encouraging them to choose life insurance over competing savings vehicles such as bank accounts, mutual funds, or bonds,” according to the Congressional Research Service. That means that the life insurance industry benefits from a substantial subsidy embedded in the tax code.
The millions of Americans who hold life insurance policies share the tax benefit. Historically, insurers marketed policies toward the broad middle class.
But because of the favorable tax treatment and the savings aspect, life insurance policies are also increasingly used by the wealthy as estate planning devices. The top 10 percent of highest-income earners own 55 percent of the investment gains built up in life insurance policies. “[A] growing proportion of the tax benefits of life insurance goes to the well-off, not to the middle class that once was the industry’s backbone,” according to the Wall Street Journal.
Have there been proposals to reform this tax preference?
There have been various proposals to eliminate the exclusion for life insurance inside buildup, though none have advanced in Congress. In 2005, President George W. Bush’s Advisory Panel on Federal Tax Reform proposed to tax life insurance inside buildup like gains on other types of savings. Deficit-reduction proposals that eliminate nearly all tax expenditures, including those published by President Obama’s National Commission on Fiscal Responsibility, and the Reform and the Bipartisan Policy Center’s Debt Reduction Task Force, would presumably eliminate this tax expenditure.
President Obama has also proposed reforms to so-called corporate-owned life insurance policies, or COLI, taken out by businesses on their executives and employees, which have sometimes been used for tax arbitrage. (For background on COLI, see this CRS report and pages 54-55 of the administration’s “Greenbook,” which explains its tax proposals.)
As a tax expenditure that subsidizes life insurance, the exclusion of inside buildup is essentially the same as a $26 billion spending program. And like all tax expenditures, its cost-effectiveness toward its policy purpose deserves ongoing review.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. Jordan Eizenga is a Policy Analyst at American Progress. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
.Tax code sections 7702 and 7702A impose certain requirements intended to curb the most investment-like insurance policies.
. The Congressional Research Service notes: “Taxing at the company level as a proxy for individual income taxation has been suggested as an alternative.” Congressional Research Service, “Tax Expenditures: Compendium of Background Material on Individual Provisions” (2010), p. 308.