Modified Endowment Contracts
Modified Endowment Contracts, or MECs, refer to the tax qualification of some life insurance policies. In this article, we are going to go over exactly what modified endowment contracts are, their taxation, and how a life insurance policy qualified as one.
Technical and Miscellaneous Revenue Act
The Technical and Miscellaneous Revenue Act of 1988, or TAMRA, was the act of legislation that created modified endowment contracts. It prevents a taxation loophole. Before TAMRA, you would fund a life insurance policy with a large sum of money that could grow tax-deferred and you could withdraw from the policy tax-free. TAMRA now limits the amount of money you can put into your insurance policy during the first 7 years of the contract. There are three qualifications that may make your insurance policy a MEC:
- You entered into the contract on or after June 20, 1988.
- Your contract meets the statutory definition of a life insurance policy.
- You fail to meet TAMRA’s 7-pay test.
TAMRA set up the 7-pay test. It determines if the total amount you paid into your insurance policy during the first 7 years is more than what is allowable. This amount is different for every policy owner. The insurance company determines the amount by your age, the cost of the insurance, your health risk ratings, assumptions about mortality rates, and current interest rates. Your insurance company should provide you with the exact amount and will alert you if you ever exceed the amount. Typically, if you ever exceed the amount you can withdraw the excess before the anniversary of your policy and avoid MEC classification.
If your life insurance policy is a MEC, the main effect is how the taxation changes. The tax treatment of MECs is similar to that of non-qualified annuities. Modified endowment contracts are taxed Last in First Out (LIFO). This means that gains are taken out first when you make a withdrawal. This is the opposite of a non-MEC life insurance policy. You do not pay tax on your cost basis. But it is the last money in line when you make a withdrawal. You also pay tax on policy loans if they are equal to the gains. The tax rate is your income tax level. In addition to the taxation, if you take money out before age 59 1/2 you will need to pay a 10% penalty. Your cost basis is not subject to this penalty. Lastly, the death benefit of your policy is tax-free for your beneficiaries.
MEC status is irreversible. So, before you decide to change your insurance policy, be sure to consult with a tax planning professional who can educate you on the benefits and ramifications of such choices.
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