Cash-value life insurance has always provided a tax-free avenue of growth with unlimited tax-free access. In 1988, Congress passed the Technical and Miscellaneous Revenue Act, TAMRA, placing limits on the amount of money that can be put into these instruments. As a result, policies that no longer comply are classified as Modified Endowment Contracts, MEC.

In this episode of Money Script Monday, Sean walks you through the potential tax implications and ideal candidates for a MEC.

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Video transcription

Hello, and welcome to another edition of Money Script Monday.

My name is Sean Brady, and today's topic is Understanding Modified Endowment Contracts.

Tax-free growth and tax-free access are some of the chief advantages of owning cash-value life insurance policies.

That's why so many people took advantage of these in the 1970s and early 1980s, because they featured substantial cash value growth. And they did this using single premium universal life contracts.

Now, they could also take withdraws, interest and principal tax free as a distribution so long as the policy remains in force during a lifetime.

Effectively, this strategy allowed policy owners and these policies to function as large scale tax shelters.

Congress however, didn't agree with the manner in which these life insurances were being utilized and they started to place limits on how these policies could be funded.

As a result, these cash value life insurance policies are subject to the 7-pay test now, and any policy that doesn't comply or fails the 7-pay test is classified as a modified endowment contract, or MEC for short.

And that's why today we're gonna talk about what a MEC is, we're gonna talk about the tax implications, and then the ideal candidate for whom a MEC might be suitable for.

What is a MEC?

So, what is a MEC?

A MEC is when premiums paid into a life insurance policy are in excess of a premium test, which is set by the Internal Revenue Code.

The IRS will still classify these policies as life insurance, but tax rules just become less favorable.

The tax rule has become more of what you would see on a nonqualified annuity when you're trying to access your cash value.

However, the death benefit is income tax free, so there's still a plus.

The MEC rules were put into effect on June 21st, 1988 with the Technical and Miscellaneous Revenue Act, also known as TAMRA.

And what TAMRA did was limit the amount of premium and how to be funded into these policies with the 7-pay tests.

Now, the 7-pay tests last for the first seven years of life insurance policy and seven years following a material change.

A material change would be something like a death benefit reduction.

If you own a policy and for whatever reason seven years down the road you decide a death benefit reduction is best for your policy, then that 7-pay test would then apply seven years following that change.

The premiums that are paid into the policy, the cumulative premiums, if they exceed the cumulative MEC limits, then that policy would fail the 7-pay test, the policy would be considered a MEC, and there may be tax consequences.

And it's really important to know that after a policy is considered a MEC, the status can never be reversed.

Tax Implications

Now that we know what a MEC is, let's talk about some of the tax implications of a modified endowment contract.

If your policy is a MEC, the general rule is death benefit is still income tax free to your beneficiaries.

But if you take a cash withdrawal from your policy, you'd be accessing the taxable gain, if any, first.

Also known as FIFO, first in, first out.

It's also important to note that if you take a cash withdrawal and you're under the age of 59 and a half, there will be a 10% federal judicial tax on that gained amount.

Remember, in order to have a taxable gain, your cash value has to be greater than the cost basis or premiums paid into the policy.

For loans from a MEC policy, they are similar to taking withdrawals from a MEC policy.

And this is really important because many people believe that loans from a MEC policy are still income tax free, and that is just not the case. Loans would be taxable up to the gain amounts.

As with withdrawals, a 10% federal additional tax on that gain would apply if you're under the age of 59 and a half.

Ideal Candidate

So, we talked about what a MEC is, we've talked about the tax implications of a MEC. For whom may a MEC be suitable for?

Who is your ideal candidate for the situation?

And remember, the death benefit is still income-tax free for beneficiaries, so this may be a useful strategy to use a MEC in estate planning purposes.

Because if you have someone that has no real intention of accessing the policy's cash value during their lifetime, then there is no real consequence of your policy being qualified as a modified endowment contract.

Possible clientele for a MEC might be someone that's age 45 and older with a need for life insurance.

You've identified some idle assets that really aren't doing much for yourself or the clients.

You want an efficient transfer of assets for financial reassurance with long term cash accumulation potential, so in case there is an emergency, you can still tap into that policy.

And you're concerned about future tax increases.

Some other situations where a MEC might be suitable are in certain college-funding strategies, or maybe some long-term care, so an asset-based long-term care policy.

Now, that concludes today's presentation. I hope I was able to shed some light on what a modified endowment contract is, their tax implications, as well as suitable clients for a MEC policy.

Thank you for attending, and we'll see you next time on Money Script Monday. Take care.