It’s possible that your permanent life insurance policy, with its cash value and tax-free interests, can become a modified endowment contract if you do not take precautionary steps to prevent it.
It is mostly the insurer’s job to provide their permanent life insurance policyholders with the rules guiding their policy and make them understand the modified endowment contract before purchasing their coverage.
Luckily, as a permanent policyholder who is a regular premium payer, one of your policy goals is to build financial goals for you and your loved ones. Yet, there are ways to handle your policy and avoid ending up with a modified contract. Your cash value is the part of your policy that holds these rules and requires you to be careful and abide by them.
What is a Modified Endowment Contract (MEC)?
A modified endowment contract is what happens to a permanent life insurance policy when a policyholder pays a premium till it exceeds the limits given by the United States federal tax law.
In other words, over-funding the cash value account of your permanent life insurance, like in the whole life insurance, will expose your policy to become MEC and attract penalties, including extra tax charges.
It might sound great that you are funding your cash value and saving more money which might serve as a backup when you are down on cash and want to borrow or withdraw from it or add to your beneficiaries. However, overdoing it does not end well because you will be causing more harm than good for yourself and your policy.
How does a Modified endowment contract work?
When a permanent life insurance policyholder pays a premium, part of the money is sent to the policy’s cash value account. It is a general procedure because all permanent life insurance comes with this cash value account and you must fund it.
When a policyholder pay the premium, the insurer divides it, takes part of it for the maintenance of the policy, and the other part goes into the cash value account. The cash value, in turn, grows tax-free interests and can be withdrawn without tax.
A life insurance coverage policy becomes a Modified endowment contract when the IRS decides that the whole of the premium paid into the policy in the first seven years has passed the designed amount by the law and is no longer fit to be called life insurance.
The policy undergoes a seven-day test when it seems like it’s about to become a MEC. The test is one way they determine offending policies, but not all permanent life insurance can go through this test.
So, a policy that finally becomes a MEC continues that way without a revert. The policy lives on with the consequences of becoming a modified endowment contract.
Criteria for a policy to become MEC
Before a life insurance policy becomes a MEC, it must qualify and pass these two criteria.
- If the policy started existing on or after 20th June 1988.
- When the policy fails to pass the seven-day test.
All life insurance policies bought before 20th June 1988 are not under this particular obligation. But once the policy undergoes any new changes, it goes under this rule.
Consequences of MEC
Policies that attract MEC remain under its consequences because they stop living up to the standard of a tax-free life insurance policy.
Tax on withdrawal
Usually, the cash value savings on a life insurance policy stays tax-free even while you withdraw from it because the withdrawal policy acts on a policy basis first. However, this changes under MEC. Under MEC, any withdrawal will become taxed as if it’s an income because it operates on gains first basis.
More 10% tax
A policyholder trying to withdraw from a MEC flagged permanent life insurance policy and still not up to fifty-nine and half years old will incur an extra 10% on the withdrawal.
What does MEC not affect?
The beneficiary benefits accumulated on the policy remain untouched by MEC and stay tax-free. Say the policyholder is not interested in the beneficiary benefits but wish to use them for other purposes.
Managing MEC on a policy
Your policy keeps running aside from the many tax implications heaved on it. The cash value keeps growing interests that are tax-free, and average life insurance (without MEC) still attracts a minor penalty for early withdrawal for policyholders not up to fifty-nine years and a half.
So, it does not mean the policy has spoiled or ended. You only feel the heat of MEC if you withdraw from the cash value account.
Policyholders who operate MEC flagged accounts may decide to stay away from withdrawals and wait till they are 60 years to avoid extra or additional penalties on the policy. Instead, the account with overfunded value will cover estate planning.
Some individuals purposely acquire MEC because they want to push in plenty of money just for the purpose of leaving a large sum of money to their loved ones. After all, beneficiary benefits stays tax-free, MEC or not. Such people do not care about withdrawing and will never withdraw.
How to avoid MEC
Suppose you want to avoid a modified endowment contract on your policy. In that case, your cash value account has to remain a little lower than the designated amount for a life insurance policy.
Another means you can build up significant money without triggering off MEC is to use the Paid-up additional insurance (PUA) policy. The paid-up additional insurance, like its name, can be added to whole life insurance, which uses dividends instead of premiums. Policyholders add the paid-up additional insurance policy as a rider.
It is crucial to understand the rules of a policy before you purchase. You see, MEC removes all the tax-advantaged benefits in a policy. Except you clearly wish for MEC, policyholders prefer to avoid modified endowment contract flag. So, ask questions and understand what works and what puts a policy in a tight corner.