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Cash-value life insurance builds savings with tax-deferred growth that can be accessed tax-free anytime through a loan. But in the past, wealthy investors and insurance companies pushed this tax break to the limit, primarily using policies as savings vehicles instead of for life insurance coverage.
Today, Congress limits how much you can pay into life insurance cash value as these policies are now subject to a seven-pay test, which limits the tax benefits of cash-value withdrawals and loans. Life insurance policies that fail this test are now classified as modified endowment contracts (MEC), which are worse for taxes.
Tax-free growth is one of the chief advantages of cash-value life insurance. Many life insurance carriers tried to take advantage of this feature in the late 1970s by offering single-premium and universal life products that featured substantial cash-value accumulation.
Policy owners could then take out both the interest and principal as a tax-free loan as long as the policy did not lapse before the owner's death. This strategy effectively allowed the policy to function as a large-scale tax shelter. However, Congress did not agree that life insurance should be used in this manner and it passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).
This act created the MEC. Before this law was passed, all withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. This meant the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. Policyholders could also access all cash value tax-free through loans.
But TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive this favorable tax treatment. Any policy that receives premiums beyond these limits automatically becomes a MEC.
In a general sense, the corridor rule states that for any life insurance policy to avoid being classified as an MEC, there must be a "corridor" of difference in dollar value between the death benefit and the cash value of the policy.
All single-premium policies are now classified as MECs. Flexible-premium policies must pass the seven-pay test in order to avoid MEC status. This test caps the amount of premium that can be paid into a flexible-premium policy over a period of seven years.
Once a policy has been classified as an MEC, it cannot regain its former tax advantages under any circumstances. The MEC classification is irrevocable.
Each policy that is now issued will have its own MEC premium limit that is based on several factors, including the age of the policy owner and the face amount of the policy. Any premium paid into the policy in excess of this limit will result in reclassification of the policy as an MEC. However, the unused cap space within this limit is cumulative. For example, if the MEC limit for a policy is $5,784 the first year and $4,000 of the premium is paid into the policy, then the excess $1,784 of the unpaid premium is carried over to the premium limit for the second year.
This limitation expires after seven years as long as no material changes occur, such as an increase in death benefit. Any material change will effectively restart the seven-year test. A decrease in the death benefit will not restart the test, but it may result in the policy being immediately classified as an MEC in some cases.
Any withdrawals from an MEC are taxed on a last-in-first-out basis (LIFO) instead of FIFO. You must take out your gains first and pay taxes before you can receive the nontaxable return of your premium payments. Furthermore, if you are under the age of 59.5, you must pay a 10% penalty for early withdrawal of your gains. The same taxes apply to cash value loans as you can no longer borrow your gains tax-free from an MEC.
The IRS has its own set of guideline premiums that must be met in order for cash value policies to retain their FIFO status. These standards apply to both flexible and single premiums and supersede those of the seven-pay test. For any given flexible-premium policy, the IRS has a single-premium limit that the cumulative annual premium payments may not exceed.
For example, the IRS may assign a five-year single-premium limit of $24,000 to a policy. If the annual MEC limit is $5,000, then the policy owner will exceed the $24,000 limit in the fifth year of the policy. Therefore the owner can only contribute $4,000 that year to avoid MEC status. They must then wait until the IRS guideline annual premiums catch up with their total premium payments in a later year.
The consequences of exceeding the IRS guideline premiums are very severe. Any policy that receives premiums above this threshold will lose all of the traditional tax benefits accorded to life insurance policies. Life insurance companies will typically disallow any premium payment that exceeds the IRS guidelines for this reason.
Despite the reduced tax benefit and other limitations of MECs, they are often marketed as an estate planning tool. They are usually touted as an alternative to annuities, which immediately become taxable upon the death of the owner. In contrast, MECs still resemble life insurance policies in that they pass their assets tax-free to heirs.
These vehicles can be appropriate if you are looking for a way to leave a tax-free inheritance to family members. For example, you might find it simpler to pay off a policy all at once with a single premium, even if it turns the life insurance into an MEC. However, you should not purchase an MEC with the intention of accessing the cash value tax-free while alive, With that being said, you could still take out the cash value as needed so long as you pay the appropriate taxes.
When a life insurance policy becomes a MEC, it still provides the same death benefit and life insurance protection. However, a MEC has more strict tax rules for taking out the cash value. You must withdraw any taxable gains first before you can withdraw your premiums tax-free. The same taxes also apply to loans.
A MEC removes the tax benefits for withdrawing or borrowing cash value in a life insurance policy. Congress set up this rule to prevent people from using life insurance cash value as a tax shelter instead of for insurance protection. Life insurance policies that receive too much in premium payments during the first seven years turn into a MEC.
A MEC can still be a good financial planning tool. If you want to leave an inheritance, a MEC provides a tax-free death benefit, just like life insurance. A MEC just does not give you the same convenient tax-free access to your cash value as a normal life insurance policy.
If you are concerned about whether a policy may become an MEC, ask your insurance agent or carrier to see what their policy is for handling excess premiums that could create problems. Insurance carriers keep track of this matter and will notify their policy owners if either the seven-pay test or the IRS guideline premiums are exceeded. For more information on MECs and their proper use, consult your insurance agent or financial advisor.