What Is the Cash Value Accumulation Test (CVAT)?

The cash value accumulation test (CVAT) is a test for determining whether a financial product can be taxed as an insurance contract rather than as an investment. The cash value accumulation test is used to make sure that the cash value of the insurance policy does not exceed the present value of all future premium payments on the policy.

Key Takeaways

  • The cash value accumulation test (CVAT) is used to determine whether a financial product should be taxed as an insurance product or an investment product.
  • CVAT is employed to test whether the cash value of the insurance policy does not exceed the present value of all future premium payments on the policy.
  • If the cash value is higher than the future payments then the product is considered to be an investment product, not an insurance product.
  • The importance of the determination is that insurance products come with many tax benefits including death benefits being exempt from taxes.
  • Insurers also use the guideline premium test (GPT), which limits the premiums paid to the death benefit whereas CVAT limits the cash value.
  • If a financial product fails the test and is determined to be an investment product, then it will be taxed at a higher tax rate; either ordinary income tax or capital gains tax.

Understanding the Cash Value Accumulation Test (CVAT)

Being able to pass the cash value accumulation test (CVAT) is incredibly important to a policyholder as well as the insurer. If an insurance product fails to pass, it is no longer considered an insurance product and is thus taxed like an investment.

Insurance policies can grow in value on a tax-deferred basis, with death benefits being exempt from income tax. Most other investments are taxed as ordinary income, meaning that failing to pass the test will lead to a higher tax rate.

The CVAT method is used when a policyholder does not want to be limited in the amount of premiums that are able to be paid into the policy and wants to maximize the death benefit that can be received. Alternatively, this method can be used when the policyholder plans to roll a large sum into the policy upfront but wants to limit the initial death benefit.

Cash Valuation Accumulation Test vs. Guideline Premium Test (GPT)

In addition to the CVAT, an insurer has the option of designing a policy so that it passes the guideline premium test (GPT). The GPT limits the premiums that a policyholder pays relative to the death benefit, unlike the CVAT, which limits the cash value relative to the death benefit.

The basic difference between these two tests is that CVAT limits the cash value relative to the death benefit, while GPT limits premiums paid relative to the death benefit. If an insurance policy fails either of these tests, then it is not considered a life insurance policy, and all income tax benefits are eliminated.

The insurer must indicate which test is going to be used on the issue date, and once the policy is issued, the insurer cannot decide to use the other test option instead. The choice of test can determine what the policy premiums, cash value, and benefits will be.

Example of the Cash Value Accumulation Test (CVAT)

Under a CVAT test, a life insurance policy's cash surrender value may never exceed the net single premium that would be required to purchase those same future benefits, resulting in tax benefits to the policyholder.

Here's an example: if a $150,000 whole life policy for a healthy 40-year-old carries a cash value of $15,000, to be eligible under this test the net single premium for this amount of coverage at that age must be at least $15,000. If the single premium is less than the cash surrender value, the policy will not pass the CVAT and won't qualify as life insurance but will be considered an investment product that will incur higher taxes.

It is critical for a policyholder to understand the difference of the product as it will directly relate to the payout that the beneficiary receives. Ensuring that the financial product qualifies as an insurance product will guarantee that the beneficiary will receive a larger payout when the policy is claimed.