As a policyholder, you may have heard about the modified endowment contract (MEC) and the restrictions that come with it. It’s essential to understand what a modified endowment contract is to avoid falling into the MEC trap. In this guide, we will dive into everything you need to know about modified endowment contracts and how to avoid them.
What is a Modified Endowment Contract?
A modified endowment contract (MEC) refers to any life insurance policy that falls under the Internal Revenue Service (IRS) classification. This classification demarcates that the life insurance policy has received excessive premium payments as compared to death benefit payouts. Once the limit is crossed, the policy status changes to a MEC. This change results in the following consequences that impact the policyholder:
- Withdrawals from the policy become taxable.
- Policyholders have to pay a 10% penalty on withdrawals before the age of 59.5.
- Death benefits remain tax-free.
- Policyholders lose the ability to take advantage of the tax-free policy loans from the policy’s cash value.
Why Do Modified Endowment Contracts Exist?
Modified Endowment Contracts came into existence with the introduction of the Technical and Miscellaneous Revenue Act (TAMRA) in 1988. The intention behind the act was to target tax shelters and fraud in life insurance policies, amongst other things.
The act defined a life insurance contract as a contract that provides a death benefit on the occurrence of the insured’s death. It should also meet the seven-pay premium test, wherein premiums are paid for seven years. If the policy meets this test, then loans and withdrawals from the policy’s cash value are tax-free, allowing for tax-deferred growth for the policyholder.
To use life insurance as a tax-shelter investment, some individuals used to pay a high premium amount. This resulted in the policy’s cash value growing faster than the death benefit. To combat this, the act introduced the Modified Endowment Contract classification, imposing additional taxes on payments made over seven years.
How to Avoid the MEC Trap
A Modified Endowment Contract designation will change your policy’s status, resulting in unfavorable tax implications. As a policyholder, you must avoid the MEC trap to take advantage of your insurance policy’s tax-free benefits. Here are some strategies to help you achieve this:
Understanding Your Policy’s Seven-Pay Premium Test
To avoid the MEC trap, you must understand your policy’s premium structure and the seven-pay premium test. Premiums paid in the first seven years of the policy determine whether your policy meets the seven-pay premium test or not. A premium structure that breaches the seven-pay premium limit will result in a MEC designation.
Opting for Low Premium Payments
One way to prevent your policy from becoming a MEC is to opt for low premium payments. Doing this will keep your policy compliant with the seven-pay premium limit. For instance, if you purchase a policy with a $1 million death benefit, you can opt for a low premium of $30,000 annually or less.
Consider Paid-Up Additions Instead of High Premiums
If you want to take advantage of the cash value buildup, you can purchase Paid-Up Additions (PUAs) instead of making high premium payments. PUAs allow policyholders to pay a lump sum into the policy, which goes towards the cash value buildup. Doing this lowers the overall premium payments, keeping the policy compliant with the seven-pay premium limit.
Be Mindful of Policy Loans
Policyholders with a non-MEC policy can borrow from the policy’s cash value tax-free. However, if your policy has a MEC designation, the IRS will tax the loan as ordinary income, resulting in unfavorable tax implications. Therefore, it’s essential to be mindful of policy loans.
Keep Track of Your Policy’s Performance and Premiums
It’s essential to keep tabs on your policy’s performance and premium payments. Failing to do so could result in the policy crossing the seven-pay limit, resulting in a MEC designation. Keeping track of your policy allows you to make necessary adjustments and prevent the policy from crossing the seven-pay premium limit.
Conclusion
In conclusion, a modified endowment contract designation makes your policy attract unfavorable tax implications. To avoid the MEC trap, it’s essential to understand and follow the seven-pay premium test, opt for low premiums, purchase Paid-Up Additions, be mindful of policy loans, and keep tabs on your policy’s performance and premiums. By doing this, you can take advantage of your policy’s tax-free benefits without the tax implications associated with a MEC designation.
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