If you have (or plan to have) a personal banking system by leveraging your whole life insurance policy, you need to understand what a modified endowment contract (MEC) is and what could lead to one.
After you learn how to prevent your life insurance policy from becoming a MEC, you will enjoy your system’s full potential without penalties and complications. That’s why today we are talking about everything you should know about a modified endowment contract.
What Is a Modified Endowment Contract (MEC)?
Under current law, if the life insurance policy is funded too quickly, it will be classified as a modified endowment contract (MEC).
MEC rules impose stiff penalties to eliminate the use of whole life insurance as a short-term savings vehicle.
What are the penalties?
If the contract is a modified endowment contract, all cash-value transactions are subject to taxation and penalties.
Funds are subject to a 10% penalty on games withdrawn before age 59 ½; this is considered our premature distribution. Distribution is made on or after 59 ½ and paid out due to death or disability and is not subject to penalty.
To simplify: if you overfund your policy, it will become taxable.
So, all the tax benefits of that policy can suddenly disappear if the policyholder isn’t familiar with the modified endowment contract and its rules.
Here’s a Bit of Background
Before 1988, individuals could place large sums of money into a cash value policy, typically in a lump sum, and the cash would grow tax-deferred until the insurer died, at which point a death benefit was paid income tax-free. Or, if those people needed cash, they could take a tax-free lifetime loan or withdrawal.
These life insurance policies were used in place of investment vehicles to avoid paying taxes. The IRS shut down that tax shelter strategy by enacting the Technical and Miscellaneous Revenue Act of 1988, also known as TAMRA.
TAMRA closed the tax loophole by creating the following:
- The concept of the modified endowment contract;
- A test to determine when a life insurance policy is reclassified as a modified endowment contract;
- New, more restrictive tax rules that would apply to all modified endowment contracts.
Under TAMRA, the tax rules for MECs discourage them from intentionally overfunding life insurance to get the most growth in tax-free income. One of the main goals of the legislation is to change life insurance from a tax-advantaged investment vehicle to a tool for estate planning and retirement income.
The seven-pay test is an IRS system used to decide whether you have overfunded your cash value life insurance. You have an annual contribution cap set by your insurance provider for your life insurance account. This limit depends on how much money it would take to pay out your policy over the next seven years.
In order to increase the amount invested and the holdings in their cash value account, life insurance policyholders may want to overpay for their policy. But if you pay over the annual limit within the first seven years, you would fail the seven-pay test, and the IRS could convert your life insurance policy into a modified endowment contract.
You can only overpay in the first seven years of a life insurance policy. But if you make a big change to your policy, like adding a rider or making the death benefit bigger, the seven-year period will start over. That’s because life insurance riders and changes to your death benefit alter the cost and value of the policy.
Tax Implications of a MEC
Your life insurance policy’s tax treatment changes when it is converted to a MEC. Your insurance withdrawals are handled similarly to those from a nonqualified annuity.
Like nonqualified annuities, MECs act as investment products that are funded with after-tax dollars. Only the earnings you receive must be taxed when money is withdrawn from a MEC. This money is viewed as regular income by the IRS.
LIFO Taxation (Last-In-First-Out)
Once the life insurance policy is reclassified as a MEC, it is subject to LIFO (last-in, first-out) taxation. At that point, cash value distributions are considered gains first and premiums last. That means the MEC owner will owe taxes on any distributions to the extent the cash value has grown. Those gains are taxed at the MEC owner’s normal income tax rate.
Let’s see an example.
Let’s say your policy has a $12,000 cash value, $10,000 in premiums, and $2,000 in gains. A cash distribution of $11,000 under LIFO would consist of $2,000 in gains and $9,000 in premiums. Under FIFO taxation, you only recorded $1,000 in taxable gains. So, LIFO, in this scenario, would be double the tax bill.
Are There Any Pros to Modified Endowment Contracts?
A MEC is typically not desired by the owner of a life insurance policy. With a modified endowment contract, many of the tax benefits of life insurance will go away, and the money in the MEC will be much harder to get to than the money in a whole life insurance policy.
Nevertheless, some people might profit from purchasing a MEC (not for life insurance) because it frequently provides a higher yield on essentially risk-free capital (i.e., greater than savings accounts or CDs) and enables the transfer of assets to beneficiaries tax-free and without probate upon the owner’s passing.
Note: Still, there are way more disadvantages, like the fact that once MEC is triggered, it can’t be undone.
How Can I Avoid a MEC Status?
Most of the time, your life insurance company will tell you that you’ve overpaid your policy and that you need to get the extra money back within a certain time frame to avoid MEC status.
With some life insurance companies, you can make an agreement to receive a check back if you overpay your permanent life insurance policy. That’s exactly what we did!
Pro tip: You can buy a Paid-Up Additions Rider (PUA) if you want to boost your cash value and death benefit and make sure you don’t put too much money into your account. The money you pay into a PUA rider may earn dividends along with the rest of your policy.
Talk to the insurance agent if you have questions about your policy. Knowing how much you can put into your life insurance policy each year will give you peace of mind and help you avoid unwanted MEC status.
Keeping your life insurance policy from becoming a MEC is only one piece of a cake.
There’s much more to know about designing and maintaining your policy, and you should take your time to learn new things.
Good luck on your financial journey!