The Modified Endowment Contract (MEC) can be your worst enemy, or your best friend. If we look at what it is, how to avoid it if necessary, and how to use it when needed, we’ll be much more capable of keeping our permanent insurance policies working for us in a powerful way. In order to present an adequate picture of the MEC, let’s first discuss a little history.
Modified Endowment Contract (MEC)
[the History, How to Avoid It, and Why You Might Want It]
Flashback to the 80’s
Do you remember the 80’s? Star Wars and Indiana Jones blew our minds. Glam bands with big hair rocked our television sets via the new MTV. And interest rates were approaching 20%. For just a minute imagine yourself in 1981 with $100,000 to invest. You could buy a 10 year government backed bond for 12%, you could invest in the stock market, or you could choose to take advantage of a permanent life insurance policy.
You’d have to qualify for the life insurance policy, but if you did, you’d find that your returns were competitive with other types of investments of the day. And then you would find out that the policy was not only competitive, but almost too good to be true! Why? Well simply put, almost all other types of investment were taxable. If you gained money, the money you gained was taxed. However, permanent life insurance policies are not taxed like other types of investments. So you could put your $100,000 into a $500,000 permanent life insurance policy, and gain 10% a year for a couple years. Then you could withdraw or take a loan against your investment gain, without paying taxes.
Are you following the logic here?
Anyone that wanted to invest in a permanent life insurance policy in the 80’s could do so in just about any amount they wanted. Sit back and watch your cash value life insurance grow and grow at a tremendous rate. And then withdraw (up to your basis) or take out a loan against it, tax free!
The reason this was possible is because life insurance policies aren’t typically taxed. So policyholders could insure themselves with one giant lump sum payment, as in my example above. Or they could pay large premium payments that far exceeded the cost of insurance, in order to quickly grow the cash value. Either way they were enjoying the tax shelter status of life insurance policies in a way that the government hadn’t anticipated.
Too Good to Be True
Things that are too good to be true often don’t last very long. That was the case for these policies back in the 80’s. Our government got wind of how people were avoiding taxation by investing large sums in small insurance policies. As a result, congress passed a few different acts to squash these tax shelters, and prevent people from using life insurance policies as a short term savings vehicle. The last of these acts was called the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This act is what created the Modified Endowment Contract and the rules that govern what policies are considered to be a MEC.
TAMRA created three criteria for life insurance policies becoming a MEC. The criteria is as follows:
- The policy was entered into after June 20, 1988.
- The policy meets the statutory definition of a life insurance policy.
- The policy must fail to meet the 7-pay test.
The first criteria and the second criteria are pretty self explanatory. You can quickly determine when your policy was written, and you probably know if it’s a life insurance policy or not. But before we address the 7-pay test, we need to mention IRC 7702.
IRC Section 7702
Congress decided that it should discourage the use of life insurance for tax avoidance. As a result, under IRC section 7702 Congress passed legislation that created limits on the amount of money that can be put into a life insurance policy in a set period of time. If you exceed those limits then the policy becomes a Modified Endowment Contract.
So what is the 7-pay test criteria?
I’m so glad that insurance people give things names that help explain what they are instead of naming it after the people that invented it or created it (like Braxton Hicks contractions for example – can’t we just call them premature contractions and make it easy on everyone involved?). A policy will fail the 7-pay test if the premiums paid by the policyholder will exceed the amount of premiums required to cause the policy to be paid up within 7 years. Get it? 7 years. What you pay. The 7-pay test.
Don’t Lose Sleep Over It
For those of you reading this and wondering if you are in trouble, rest assured that it’s not something to lose sleep over these days. Your insurance company typically performs MEC tests monthly on their policies, so you don’t have to worry about accidentally triggering the qualification and not being notified. You will get a warning.
And even if your policy premiums exceed the 7-pay test, the government gives your insurer 60 days notice to return the overage to you. All that to say, it’s unlikely you’ll need to get out your calculator and do some heavy math calculations. Your insurer is doing the math for you. For peace of mind, you can always call your agent and ask them what the max-pay is for the year. If your max pay is 20k in premiums annually, and you’re paying 1k per month, you’ll know that you’re well within the limits.
What if My Policy MECs?
So now we know how the MEC came into existence and why. We also know how a life insurance policy will be considered a MEC. Now let’s talk about what changes will happen to your policy if it becomes a MEC.
One of the key benefits of the permanent life insurance policy, is that the cash value grows tax deferred and withdrawals are taken out on a First In – First Out (FIFO) basis. Which means that you can take out withdrawals tax free up to the cash value contributions you have paid in premiums.
But note that…
If your policy becomes a MEC, this advantage (FIFO) goes away and the policy is treated like a typical retirement vehicle. Withdrawals will be Last In – First Out (LIFO), which means that the withdrawals will come from the interest on your cash value first, and will therefore be taxed as regular income (typically higher because it’s investment income).
In addition, the MEC withdrawals for those that are under 59.5 years of age, are subject to a 10% penalty, just like other retirement vehicles.
And finally, loans from the cash value are treated as standard income, so they are taxable as well.
In a nutshell, if your life insurance policy becomes a MEC, you’ll lose all the tax benefits that it maintains prior to the death benefit. That is a huge ugly deal for many people that invested in a permanent life insurance policy. And that is why every policy that is sold these days, is required to have an NAIC compliant illustration that outlines the years in which your policy is at risk for becoming a MEC. And the illustration will also specify the 7-pay premium, which is the maximum amount you can pay in premiums each month without triggering the MEC. The 7-pay premium is helpful to determine the additional cash you can contribute to your cash value without triggering the MEC.
Why Some People Choose to “MEC”
For most people a Modified Endowment Contract is to be avoided at all costs, but for some investors, it can be a great tool and just what their portfolio needed. Remember, that even though a MEC loses it’s tax advantages prior to the death benefit, it still maintains them post benefit. Meaning that the death benefit is still a life insurance benefit, and is therefore tax exempt. And just like other life insurance benefits it has advantages over other basic retirement vehicles. The death benefit from a MEC is free from probate for a named beneficiary, is incontestable and private. And among other benefits it is protected from creditors in many states.
These benefits and others make the MEC something that certain investors may choose to round out their portfolio. If they don’t need access to the cash prior to death, the MEC is a great tool for an investor to use to provide for their loved ones after they’re gone.
Insurance can be complicated, but it doesn’t have to keep you up at night. Talk to a broker that you trust and get advice that suits the needs of you and your family. The professionals at Insurance and Estate Strategies are here to help.
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