IRC 817(h) Diversification Requirements for Variable Contracts

Under Internal Revenue Code Section 817(h), a variable annuity or variable life insurance contract keeps its tax-deferred status only if the segregated asset account behind it spreads its investments across multiple issuers. The IRC 817(h) diversification requirements are a set of percentage caps applied quarterly: no single investment above 55% of account value, no two above 70%, no three above 80%, and no four above 90%. Miss those limits and fail to cure, and the contract stops being treated as insurance or an annuity for tax purposes, with every year of deferred gain pulled into current income.¹

The rules apply to variable life insurance and variable annuities sold outside qualified retirement plans. Pension plan contracts are carved out.¹

The Four Percentage Caps

Treasury Regulation 1.817-5 sets out the test that a segregated account must satisfy on each measurement date:

No single investment may exceed 55% of total account value.
The two largest investments together may not exceed 70%.
The three largest may not exceed 80%.
The four largest may not exceed 90%.

An “investment” means all securities from the same issuer. Stocks and bonds from the same corporation get combined.² An account needs at least five distinct issuers to have any chance of passing, and usually many more, because the caps are measured against current market value rather than cost. A position purchased at 50% of the account can drift past 55% on a strong quarter without the insurer trading a share.

When the Test Is Run

Compliance is measured at the end of each calendar quarter: March 31, June 30, September 30, and December 31. If the account is off-limits on the snapshot date, the insurer has a 30-day window to bring it back into compliance. Cure within those 30 days and the account is treated as diversified for the full quarter.³

Startup Grace Periods

New accounts get time to build a diversified portfolio. Accounts that don’t hold real property are automatically treated as diversified for the first year after creation, regardless of composition. Real property accounts get until their fifth anniversary, or until they stop qualifying as real property accounts, whichever comes first.³

Inadvertent Failures

Even after the 30-day cure period lapses, the account isn’t necessarily lost. If the insurer or policyholder can show the IRS that the failure was inadvertent, that the account was corrected within a reasonable time after discovery, and that the insurer agrees to any required payments or adjustments, the account can be treated as compliant throughout the problem period.⁴ The formal process for that fix is Revenue Procedure 2008-41, discussed below.

Look-Through Treatment for Pooled Funds

Most variable contracts don’t own individual securities. The segregated account invests in a regulated investment company, partnership, or trust that pools assets from many insurance products. Without a special rule, the entire interest in that fund would count as one investment, and the 55% cap would be blown almost by definition.

The look-through rule solves that. The insurer disregards the fund wrapper and treats each of the fund’s underlying holdings as if the segregated account owned them directly, on a pro-rata basis.¹ A fund holding 200 stocks becomes 200 separate investments for diversification purposes. If the segregated account owns 10% of the fund, it counts as owning 10% of each underlying holding.²

Look-through is available only if every beneficial interest in the fund is held by a permitted investor: insurance company segregated accounts, insurer general accounts under specified conditions, fund managers, qualified pension and retirement plan trustees, Section 529 qualified tuition programs, or foreign pension plans maintained primarily for nonresident aliens.⁴ A single outside investor kills look-through for the whole fund, at which point the segregated account’s interest collapses back into a single investment and the 55% cap almost always fails.

The Treasury Securities Exception (Variable Life Only)

Section 817(h)(3) treats U.S. Treasury securities held in a variable life insurance segregated account as automatically diversified, no matter the concentration.¹ For mixed accounts, the regulation raises each of the four percentage caps by half the percentage that Treasuries represent of total account value, then applies the adjusted test only to the non-Treasury portion.⁴

This exception does not extend to variable annuities. A variable annuity account concentrated in Treasuries still has to satisfy the ordinary percentage caps.

Diversification Isn’t Enough on Its Own

A separate doctrine, investor control, runs alongside 817(h). Even if the percentages check out, a policyholder who exercises too much control over specific investments inside the account is treated as the true owner of those assets for tax purposes, and the tax deferral disappears.⁵

The IRS applies two prongs. The first asks whether the policyholder has enough influence over specific investment decisions. The second asks whether the underlying fund is available for purchase outside of insurance or annuity contracts. Triggering either prong makes the policyholder the deemed owner.⁶

Choosing among broad investment strategies or pre-selected sub-accounts is fine. Reallocating between sub-accounts is fine. Directing the insurer to buy, sell, or hold specific securities, or dictating trade timing, is not. There is no published safe harbor for the maximum number of sub-accounts an insurer can offer; Revenue Ruling 2003-91 addressed a fact pattern with up to 20 and found no investor control on those facts, but the IRS treated that as fact-specific rather than a universal ceiling.⁵ On the public-availability prong, a fund not registered under the Investment Company Act of 1940 and offered only through insurance accounts is on stronger ground than one marketed alongside retail share classes.

What Happens When a Contract Fails

A contract that fails the diversification test loses its status as an annuity, endowment, or life insurance contract for that quarter and every quarter until the failure is cured.² The policyholder must report the “income on the contract” as ordinary income.

For life insurance and endowment contracts, that income is the increase in net surrender value during the year, plus the cost of life insurance protection provided, minus premiums paid.⁷ Disqualified variable annuities are taxed under the same formula; the regulation applies section 7702(g) and (h) to them by cross-reference.²

The harder blow is the retroactive catch-up. When a contract ceases to qualify, all prior years of deferred income are treated as received in the year of failure.⁷ A decade of tax-deferred growth can land as one year’s ordinary income. Federal ordinary income rates reach 37% for 2026,⁸ and state taxes stack on top.

The Correction Path Runs Through the Insurer

Revenue Procedure 2008-41 provides a formal path to fix an inadvertent failure and preserve the contract’s tax status. Only the issuing insurance company can invoke it; the policyholder cannot file on their own behalf.⁹

The insurer submits a private letter ruling request that identifies the non-compliant quarters, shows the failure was inadvertent, and demonstrates that the portfolio was brought back into compliance within a reasonable time after discovery. There is no fixed filing deadline, but delay works against the insurer’s case. The insurer must also propose a closing agreement and make a payment to Treasury, capped at the lesser of $5,000,000 or 5% of the segregated account’s total asset value measured 30 days after the last day of each non-compliant quarter. After the IRS executes the agreement, the insurer has 60 days to pay.⁹

For a policyholder, the practical consequence is that this safety net exists but depends entirely on the insurer acting. If the insurer catches a failure and files promptly, the impact may never reach you. If it doesn’t, the retroactive tax hit on every dollar of deferred gain is yours.

1
Office of the Law Revision Counsel. 26 USC 817 – Treatment of Variable Contracts
2
eCFR. 26 CFR 1.817-5 – Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts
3
GovInfo. 26 CFR 1.817-5 – Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts
4
eCFR. 26 CFR 1.817-5 – Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts
5
Internal Revenue Service. Revenue Ruling 2003-91
6
Internal Revenue Service. Private Letter Ruling 202041002
7
Office of the Law Revision Counsel. 26 USC 7702 – Life Insurance Contract Defined
8
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
9
Internal Revenue Service. Revenue Procedure 2008-41