What Is Modified Premium Whole Life Insurance – A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits due to excess cash. When the Internal Revenue Service (IRS) relabels your life insurance policy as a MEC, it loses the tax breaks for withdrawals and loans you make from the policy. This permanent change can happen when you pay excess premiums in too short a period.
Generous tax benefits are granted in the United States to permanent life insurance contracts, but if you put too much money into one, it loses its status as “insurance” and becomes an investment vehicle instead. Your policy’s MEC limits will depend on its terms and the amount of the death benefit. Your insurance company will alert you if a policy is about to become MEC, or if a policy is about to become MEC.
What Is Modified Premium Whole Life Insurance
A modified endowment contract occurs when the IRS no longer recognizes a policy as a life insurance contract because the total premiums collected and cash value exceed the limits of federal tax law. The limit is set based on IRS rules regarding the maximum amount of premiums that can be paid into the policy in its first seven years. This classification seeks to combat the possibility of calling a financial product “life insurance” to avoid taxes.
How Whole Life Insurance Works
In the 1970s, many life insurers took advantage of the tax-free growth of many of their products by offering policies with significant accumulation of cash value. Policyholders could withdraw interest and principal in the form of a tax-free loan, making the policies de facto tax shelters. Federal legislation passed in 1988 limited this type of use.
Some life insurance policyholders, often high-net-worth individuals, choose to overfund a policy with a cash value component, then take periodic loans from it during their lifetime, making the policy an investment. But doing this reduces the policy’s death benefit for heirs. If your children are grown and your retirement resources are sufficient, this approach may appeal but be aware of the cash value limits that may push your policy into MEC status.
The IRS requires that a life insurance policy meet a strict set of criteria to avoid being a MEC.
The seven-pay test determines whether the total amount of premiums paid into a life insurance policy within the first seven years is more than what you would need to pay it off in full for those seven years. The policies become MECs when the premiums paid to the policy are greater than what was to be paid within that seven-year period.
What Is A Modified Endowment Contract (mec)?
Life insurance policies made before June 20, 1988, are not subject to restrictions on paying premiums over the money allowed under federal laws. However, renewal of an older life insurance policy after this date is considered a new policy and must be subject to the seven pay test.
A life insurance policy can avoid MEC status as long as the amount of money in the policy remains a certain amount below the amount of the death benefit (known as the corridor).
If you use a policy to accumulate cash value, one solution to avoid MEC status is to increase the death benefit through paid-up additional insurance (PUA), which raises the pathway ceiling. Whole life insurance coverage is added to the PUA insurance purchased with the policy dividends. It’s like little packets of life insurance that are fully paid for.
The cost basis within the MEC and withdrawals from one are not subject to tax. In the case of insurance, the cost basis is the total amount you paid into an asset such as a permanent life insurance policy. It is usually calculated as the premiums you have paid. Any cash value balance above what you paid in premiums will count as your interest earnings. (quote on north west cost basis)
Modified Endowment Contract (mec)
Unlike traditional life insurance policies, taxes on gains are treated as regular income on MEC withdrawals under a last-in-first-out (LIFO) accounting methodology. This taxation of payouts is worse for the MEC policyholder because it provides for taxable interest to be distributed first, rather than the tax-free principal amount, as is the case with a ‘first-in, first-out’ methodology ( FIFO) (reference FIFO to LIFO).
In addition, the taxation of withdrawals under MEC is similar to that of non-qualified annuity withdrawals. For withdrawals before age 59 1/2, you may have to pay a 10% early withdrawal penalty to the IRS.
Another serious disadvantage of MEC is that it removes the tax benefits for policy loans. In a traditional life insurance policy, you can borrow your cash value, including your earnings above premiums paid, without incurring income tax. In MEC, your gains from borrowing are counted as taxable withdrawals. The 10% early penalty before age 59 1/2 also applies. Again, loans operate under LIFO, so gains come out first. After you realize your winnings, you could borrow the remaining cash value that represents your premiums paid without taxes owed to you (Thrivent)
Like traditional life insurance policies, MEC death benefits are not subject to tax. Amended endowment contracts are typically purchased by individuals who are interested in tax-advantaged investment policies, and do not intend to make pre-death policy withdrawals.
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The tax-free death benefit makes MECs useful for estate planning purposes, provided the estate can meet the qualifying criteria. In addition, policy owners who do not withdraw can pass on a significant amount of money to their beneficiaries.
Some people may benefit from buying a MEC, even if it is not for life insurance, as it often offers a higher return on risk-free money; better return than savings accounts or certificates of deposit (CDs).
MECs still provide a way to borrow against the cash value component, while living. However, there are taxes in place for realizing policy earnings even through a loan.
With MEC, withdrawals and loans are taxed and may be penalized if early, just like withdrawals from non-qualified annuities. However, death benefits are tax free.
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Access to funds within a MEC will be significantly less than in a life insurance policy, in part because of the potential tax assessed on withdrawals and loans.
Although borrowing against the cash value may continue with MEC, this will reduce the amount of benefit paid to heirs when the policy owner dies.
Taxes on gains are regular income for MEC withdrawals under a last-in-first-out accounting methodology, meaning interest is paid before principal. However, the cost basis, or the total amount of premiums paid, in MEC withdrawals is not subject to taxation on withdrawals.
MEC is triggered if the amount of cash in a permanent life insurance policy exceeds the legal limits for it to be classified as insurance. The IRS uses a seven-wage test to determine MEC status. It considers whether the premiums paid during the first seven years of the policy would exceed the amount for the policy to be paid after seven years.
The Magic Of Using Life Insurance Riders
A life insurance policy can avoid MEC status as long as the amount of money in the policy under the required path remains below the death benefit. If you use a policy to accumulate cash value, one solution is to increase the death benefit through paid-up additional insurance (PUA), which raises the upper limit of the pathway.
Withdrawals are taxed the same as those from a non-qualified annuity. For withdrawals before age 59½, a 10% penalty may apply. Like traditional life insurance policies, MEC death benefits are not subject to tax.
Generally, converting a life insurance policy to a MEC is not a good idea. This is because the MEC will lose many of its tax advantages that were in place when it was classified as life insurance. However, in certain circumstances an MEC can be deliberately created as an estate planning tool.
A MEC is a cash value life insurance policy that has been stripped of its tax benefits because there is too much money in it. When reclassified by the IRS as a MEC, policy withdrawals and loans are taxed. It is a permanent change and is generally disadvantageous for most policyholders, but MECs may be useful for some as they provide lower risk returns than savings accounts and can facilitate the transfer of assets on death of the owner.
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