Life Insurance: Maximizing Your Money, Securing Your Future

Life insurance policies that offer cash accumulation in addition to the death benefit, such as whole life insurance, universal life insurance, and other types of permanent life insurance, may be subject to the Modified Endowment Contract (MEC) rule. This rule was created by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) to prevent people from using life insurance as a tax shelter. If a life insurance policy is deemed to have been overfunded, it will be reclassified as an MEC by the IRS, resulting in the loss of tax benefits for withdrawals and loans.

Overfunding a life insurance policy

However, it is important to note that overfunding a life insurance policy can also have adverse tax consequences if certain limits are exceeded. One such consequence is the policy being reclassified as a Modified Endowment Contract (MEC). This occurs when the total premiums paid into the policy exceed the federal tax law limits within the first seven years of the policy. Once a policy becomes an MEC, it loses its favourable tax treatment, and withdrawals and loans from the policy become taxable.

To avoid turning a life insurance policy into an MEC, it is crucial to consult with a financial representative and tax professional to understand the implications and determine if overfunding is the right strategy for your needs. They can help you structure your policy to maximise its benefits without triggering MEC status.

Advantages of Overfunding

• Access to cash: Overfunding a life insurance policy can provide a pool of tax-advantaged money that can be accessed during your lifetime through withdrawals or loans.
• Tax-deferred growth: Overfunding can result in significant cash value accumulation, and taxes on those investment returns are deferred until the funds are withdrawn.
• Tax-advantaged death benefits: Life insurance policies typically offer tax-advantaged death benefits to beneficiaries after the policyholder's death.

Disadvantages of Overfunding

• Risk of creating an MEC: If contributions exceed federal limits, the policy may turn into an MEC, resulting in unfavourable tax treatment of distributions.
• Fees: Permanent life insurance policies often have higher fees than term life insurance, and these fees can reduce the potential return on investment.
• Complexity: Overfunded life insurance policies can be complex and require careful management to avoid tax pitfalls.

Tax consequences of MECs

A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. Once the Internal Revenue Service (IRS) relabels your life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans that you make from the policy. This permanent change can happen when you pay excess premiums in too short a period.

The cost basis within the MEC and withdrawals from one aren't subject to taxation. In the case of insurance, the cost basis equals the total amount you paid into an asset such as a permanent life insurance policy. It usually is figured as the premiums you paid. Any cash value balance above what you paid in premiums counts as your interest gains.

Unlike traditional life insurance policies, taxes on gains are considered regular income for MEC withdrawals under last-in-first-out (LIFO) accounting methodology. This taxation of payouts is unfavourable for an MEC policyholder because it provides for taxable interest to be distributed first, rather than the tax-free principal, as with first-in-first-out (FIFO) methodology.

In addition, the taxation of withdrawals under an MEC is similar to that of non-qualified annuity withdrawals. For withdrawals before the age of 59 1/2, you may need to pay the IRS a premature withdrawal penalty of 10%.

Another serious drawback with an 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 owing income tax. In an MEC, taking out your gains through a loan counts as a taxable withdrawal. The 10% premature penalty also applies before the age of 59 1/2. Once again, loans operate under LIFO, so gains come out first. After you've taken out your gains, you could borrow the remaining cash value representing your premiums paid without owing taxes.

As with traditional life insurance policies, MEC death benefits aren't subject to taxation. Modified endowment contracts are usually purchased by individuals who are interested in tax-sheltered, investment-rich policies, and who don't intend to make pre-death policy withdrawals.

The tax-free death benefit makes MECs useful for estate-planning purposes, provided the estate can meet qualifying criteria. Furthermore, policy owners who don't take withdrawals can pass on a significant sum of money to their beneficiaries.

History of MECs

Modified Endowment Contracts (MECs) came into existence in the late 1980s, after interest rates on cash-value life insurance policies reached 20%. These policies were not only impressive in terms of interest rates but also avoided the taxes that more traditional investments faced. This was because of how the IRS taxed permanent cash-value life insurance policies.

Tax-deferred cash value grew without tax, and the first-in, first-out (FIFO) method was used to withdraw funds. This meant that policyholders could access their money tax-free, up to the cash value of the contributions they had paid through their premiums.

Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) of 1988 to discourage investors from using life insurance to avoid federal income taxes. TAMRA created three criteria for life insurance policies to become MECs:

• The policy was entered into after 20 June 1988.
• The policy meets the statutory definition of a life insurance contract.
• The policy must fail to meet the seven-pay test.

The seven-pay test assesses if the premiums paid over seven years exceed the amount required to pay off the policy. If the policy fails this test, it is reclassified as an MEC by the IRS and loses its tax benefits.

Avoiding MEC classification

A life insurance policy can avoid triggering MEC status as long as the amount of cash held in the policy remains beneath the required corridor below the death benefit. This is known as the "corridor rule". The corridor is the difference in dollar value between the death benefit and the cash value of the policy.

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 corridor's ceiling. PUA insurance is added whole life insurance coverage purchased with the policy’s dividends. It's like small packets of life insurance that are entirely paid for.

Each policy has its own MEC premium limit, which is based on factors including the age of the policy owner and the face amount of the policy. Any premium paid into the policy that exceeds this limit will result in reclassification as an MEC.

The MEC classification is permanent and cannot be reversed.

To avoid MEC status, it is important to stay informed about the maximum allowable premium payments. Insurance companies typically conduct MEC tests and notify policyholders if there is a risk of their policy becoming an MEC.

The IRS has its own set of guideline premiums that must be met for cash value policies to retain their tax-free status. These standards apply to both flexible and single premiums and supersede the seven-pay test.

Pros and cons of MECs

Pros of MECs

• They offer a higher yield on low-risk funds than some alternatives.
• They allow for a smooth, tax-free asset transfer after the holder's death.
• They can be borrowed against, although taxes apply.
• They maintain tax-free death benefits.
• They help avoid probate.
• They offer creditor protection.
• They provide liquidity.
• They can be used as an alternative to annuities, which become taxable upon the owner's death.
• They can be used as an alternative to other basic retirement vehicles.
• They can be used to accelerate the death benefit due to chronic illness, serving as an alternative or addition to long-term care insurance.

Cons of MECs

• They erase tax advantages for withdrawals and loans.
• The cash value in the policy becomes less accessible.
• Borrowing may reduce the death benefit for heirs.
• Withdrawals are taxed and possibly penalized if early, similar to those taken from non-qualified annuities.
• They can be disadvantageous for most policyholders.

Frequently asked questions