As you consider your financial plan, one valuable tool could be a permanent or cash value life insurance policy. It could provide financial stability for a loved one after you pass and help you build cash value for your lifetime. However, it's important to understand the federal rules for these policies, as it could impact your tax situation. One good example is a modified endowment contract, or MEC.
What is a modified endowment contract?
A MEC is a life insurance policy that exceeds certain IRS premium limits during the first seven years. This could happen if it is overfunded or has an accelerated payment schedule. If a life insurance policy is designated as a MEC, it loses some of its cash value tax advantages. Let's break down what that means for you.
What policies can become MECs?
All cash value policies issued on or after June 21, 1988, are subject to MEC rules. That includes policies such as universal life insurance, variable life insurance, and whole life insurance.
Older policies are generally exempt unless they undergo material changes. Once a policy has been classified as an MEC, it can't go back to being a regular life insurance policy.
How does a policy become a MEC?
How does the IRS determine which policies should be classified as MECs? The agency uses the "7-pay test" to determine if you've overpaid into the policy.
Understanding the '7-pay test'
The 7-pay test is the maximum amount of premium you can pay in the first seven years. The limit depends on factors like the insured's age, sex, and policy design. Insurance companies calculate this using IRS guidelines.
What happens after the first seven years?
MEC classification could still be triggered after seven years due to "material" changes to the policy.
What is a 'material' policy change?
Material policy changes include an increase in the death benefit, an addition or increases of qualified riders or benefits, or formal policy exchanges like an IRS section 1035 exchange.
Material changes to a life insurance policy trigger a new 7-pay test and reset the testing period. However, increases due to interest, dividends, or cost-of-living adjustments might be excluded.
If you exchange a MEC for another policy, the new policy will automatically be classified as a MEC.
What if you reduce the policy benefits?
Reducing a policy's death benefit won’t help you avoid MEC status. Instead, it could reset the 7-pay test and trigger MEC status. The IRS's 7-pay test is based on the death benefit, so reducing it lowers the maximum premium threshold. That means the amount you paid in prior years could now exceed the new lower limit.
The tax implications of MECs
If a policy is classified as a MEC, the tax-free death benefit remains, but borrowing against the cash value is no longer tax free. Loans and withdrawals are taxable. Gains are taxed on a last in, first out, or LIFO, basis, meaning earnings are taxed before principal.
However, the death benefit remains income tax-free to your beneficiaries. If the cash value does not exceed the premiums paid and there are no gains, then the withdrawal would be considered a return of premiums and non-taxable.
Taxes on withdrawals and loans
With a MEC, the LIFO tax approach means that distributions like withdrawals, loans and assignments are treated as if you are pulling out taxable gains or interest first. You'll pay ordinary income tax on any distribution until all gains have been depleted.
With a non-MEC, your withdrawals of cash value are treated as first in, first out, or FIFO, with a tax-free return of your premium first. You only pay taxes after you have withdrawn all your principal. Policy loans are usually tax-free.
10% penalty on early withdrawals
You could pay a penalty tax on a MEC if you make your withdrawals too early. Distributions of gains from a MEC before age 59½ are typically subject to a 10% penalty, with a few exceptions such as a disability or taking annuitized payments.
Can you correct MEC classification?
Insurers might be able to correct accidental overfunding errors. They typically have a 60-day window from the policy anniversary to refund any excess premium with interest to the policyholder to avoid triggering MEC status and must submit documentation to the IRS.
Non-forfeiture rates and MEC status
Legislative changes to non-forfeiture interest rates can also impact whether a policy becomes a MEC. These rates are used to calculate the guaranteed minimum values within a life insurance policy. If the required non-forfeiture interest rate increases, the required premium to fund the policy could also increase, which could cause the policy to fail the 7-pay test and become a MEC.
Not sure how non-forfeiture rate changes could impact your policy? These steps can help:
- Contact your insurer. Your insurance company can help you understand how regulatory change will affect your policy.
- Ask for updated illustrations. Including new non-forfeiture rate assumptions can help you plan.
- Review and adjust. If necessary, work with your insurer to see if it is possible to adjust the policy to avoid MEC status.
Is a MEC always a bad thing?
MEC classification can be a concern if your primary goal is to access the cash value during your lifetime. However, despite the tax implications, MECs can still be useful in certain situations.
When a MEC might be OK
If your goal is to leave the largest possible tax-free death benefit for your beneficiaries and you don't plan on accessing the cash value during your lifetime, MEC status might not be as much of a concern.
A MEC's tax-free death benefit can be a good way to smoothly transfer wealth, and a good way for high net-worth individuals to use life insurance for estate equalization, charitable giving or funding generational trusts, particularly if combined with an irrevocable trust.
When you might want to avoid a MEC
MECs are less ideal if you're looking for tax-advantaged access to the policy's cash value. If you think you’ll need to borrow from or make withdrawals from your policy, MECs' LIFO tax treatment could hurt you.
The complex rules around MECs also mean you need to be careful that your premium payments do not accidentally trigger MEC status. You may need help from an insurance or financial professional.
And remember, once a policy becomes a MEC, the classification is permanent. That's why it's crucial to understand the tax implications and potential penalties.
The bottom line
Modified endowment contracts have specific tax rules that distinguish them from traditional life insurance policies. While they may not be ideal for everyone, they can be a valuable tool for estate planning and wealth transfer. Be sure to understand the implications and work with a qualified financial professional to determine how a MEC impacts your goals.