Deposit Account Fund Life Insurance: What You Need To Know

A Premium Deposit Account (PDA) is a special account used to fund Indexed Universal Life Insurance. Policyholders can deposit a lump sum into the PDA, which funds the policy's premiums over time. The deposited funds earn interest, reducing the effective cost of insurance premiums. The insurance company will pay a competitive interest rate on the funds that are on deposit, which allows the policyholder to earn interest on the premium dollars before they are even paid into the policy. Premium payments are automatically taken from the PDA and paid into the policy, so the policyholder doesn't have to worry about making payments year after year.

Premium deposit accounts

A Premium Deposit Account (PDA) is a special account used to fund Indexed Universal Life Insurance (IUL). Policyholders can deposit a lump sum into the PDA, which funds the policy's premiums over time. The deposited funds earn interest, reducing the effective cost of insurance premiums.

The PDA is designed for life insurance applicants who want to deposit a lump sum of money into a life insurance policy. Instead of going directly into the policy, the money is deposited into a side fund that earns interest. The premiums for the policy are paid out of the premium deposit account over a 3 to 10-year period. This eliminates the possibility that the insurance policy could become a modified endowment contract (MEC).

The benefits of using a PDA to fund an IUL policy include:

• Earning competitive interest on deposited funds.
• Automatic premium payments from the PDA.
• Avoiding the policy being classified as a Modified Endowment Contract, which has tax implications.

When setting up a PDA, it is important to consider the following:

• Minimum and maximum number of payments required.
• Minimum and maximum deposit amount.
• The cost of the PDA, if any.
• Interest rate and schedule.
• Penalties for canceling the premium deposit account.
• Who receives the unused funds if death occurs before the account is exhausted.

Some companies that offer Premium Deposit Accounts include:

• Allianz Life Insurance Company
• North American Life Insurance Company
• Minnesota Life Insurance Company

Modified endowment contracts

A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. Once the Internal Revenue Service (IRS) reclassifies a life insurance policy as an MEC, it loses its tax breaks for withdrawals and loans. This permanent change can occur when excess premiums are paid in too short a period.

Permanent life insurance contracts are generally granted generous tax advantages in the U.S. However, if you put too much cash into one, it loses its status as "insurance" and becomes an investment vehicle instead. The MEC limits for a policy depend on its terms and death benefit amount. Your insurance company will warn you if a policy is about to become, or has become, an MEC.

A life insurance policy must fail to meet federal guidelines called the "seven-pay test" to be classified as an MEC. The IRS uses the "seven-pay" test to determine whether to convert a life insurance policy into an MEC. If you put too much money into your policy in the first seven years, it becomes an MEC.

The 'seven-pay' test determines how much you can pay into your account each year. This limit varies depending on the policy. For example, if you have a $200,000 policy, and your insurer sets your seven-pay or MEC limit at $4,500 a year for the first seven years of the contract, your policy becomes an MEC if you pay more than that amount even once. If you make any changes to the policy, the seven-year timer resets.

A major disadvantage of an MEC for most policyholders is that withdrawals are taxed and possibly penalized if made early, similar to those taken from non-qualified annuities. MECs may be useful because they often offer a better low-risk yield than savings accounts and can ease the transfer of assets upon the owner's death.

Whole life insurance

The premiums for whole life insurance tend to be much higher than for term life insurance. For example, according to Covr Financial Technologies, a healthy 40-year-old man can expect to pay an average annual premium of $6,408 for a $500,000 whole life insurance policy, while the same coverage with a term life policy would cost him around $334 per year. Due to the high cost, whole life insurance may not be suitable for those purely seeking life insurance coverage. Additionally, the cash value of whole life insurance policies can be slow to grow, taking 10 to 15 years or longer to build up enough cash value to borrow against. The rate of return on the cash value is also typically low, ranging from 1% to 3.5%.

Universal life insurance

Like all permanent life insurance, universal life insurance has a built-in cash value that grows over time and earns interest. You can take out policy loans against the cash value, use it to pay your premiums, or even use your coverage for cash to supplement your income in retirement. The policy's cash value grows on a tax-deferred basis, so no taxes are owed on current earnings or interest. Also, the death benefit is paid income-tax-free to beneficiaries.

The flexibility and freedom of universal life also mean that there are fewer guarantees. In a whole life policy, the premiums, cash value growth, and death benefit are guaranteed not to change. With a Universal Life Insurance Policy, all these things are designed to be flexible. However, the amount of premium you pay affects cash value growth, and as you use funds from the cash value, it will affect the amount your family receives when you're gone. It could even cause the policy to lapse, so you should stay in regular contact with your financial professional to ensure your policy continues to meet your needs.

Tax implications

A Premium Deposit Account (PDA) is a special account used to fund Indexed Universal Life Insurance. Policyholders can deposit a lump sum into the PDA, which funds the policy's premiums over time. The deposited funds earn interest, reducing the effective cost of insurance premiums.

The interest earned in a PDA is taxable and will be reported as interest income. A 1099 form will be issued each year interest is accrued and the PDA is in force. The interest income is dependent on the product and the number of annual planned premium payments from the PDA.

If the PDA is terminated, interest will be paid on the balance of each deposit made to the PDA and is calculated using the Minimum PDA Guaranteed Annual Interest Rate. In some states, interest may be paid upon death or PDA termination and will be calculated using the Minimum PDA Annual Interest Rate.

The owner of the PDA Agreement and the life insurance policy must be the same. The interest credited when used to pay policy premiums will be reported as taxable income to the policy owner.

The Premium Deposit Account Agreement has restrictions that may result in termination before all planned premiums are paid, which may result in the loss of expected interest.

PDA insurance is a solid solution for consumers wishing to purchase Indexed Universal Life Insurance with one lump-sum payment.

Whole Life Insurance and Taxes

Whole life insurance provides a means to cover tax liabilities simultaneously, with tax-efficient investments enabling you to accumulate cash value that can be accessed tax-free during your lifetime and creating an income-tax-free inheritance for your beneficiaries upon your death.

Withdrawals from cash value may trigger income taxes on gains, but loans provide tax-free access to the funds.

Whole life insurance policies build cash value that can be utilized during your lifetime. The cash value within a whole life insurance policy grows tax-free.

Taxation of Death Benefits

The death benefit from a whole life insurance policy is entirely income-tax-free for beneficiaries, even though the policy is not considered a tax-advantaged account.

While estate taxes may apply to life insurance death benefits, the estate tax exemption is typically high. At the federal level, significant property transfers at death, including the death benefit of whole life insurance policies, can often be accommodated within this exemption threshold.

If your estate is the beneficiary of your life insurance policy, the death benefit may be subject to estate taxes. In 2024, the federal estate tax ranges from 18% to 40%, depending on how much of the estate is over $13.61 million, the exclusion limit.

Taxation of Employer-Paid Group Life Insurance

If you are receiving proceeds from an employer-paid life insurance policy, any death benefit beyond $50,000 is taxed as income, according to the IRS.

Taxation of Installment Payments

If you receive a policy payout in installments rather than as a lump sum, any interest that accrues is taxable. The principal death benefit is still not taxed.

Frequently asked questions