What Is the Cash Value Accumulation Test?

Cash value accumulation test (CVAT) is a test for determining whether a financial product can be taxed as an insurance contract rather than 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.

Understanding the Cash Value Accumulation Test

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.

In addition to the CVAT, an insurer has the option of designing a policy so that it passes the guideline premium test or 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.

How the Cash Value Accumulation Test Works

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.

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.