Many people opt for cash value life insurance because of the tax-deferred cash value component. But what if you put too much money into one?
The answer is it could change into a modified endowment contract (MEC). When this happens, you can lose the tax benefits. So, if you’re buying a policy with the idea of using cash value withdrawals in the future, you should try to keep MEC status at bay.
However, when you use MECs correctly, they can be beneficial estate planning instruments. But it’s easy to get caught up in unnecessary taxes and fees.
So let’s learn how you can avoid your life insurance policy becoming a MEC. And find out what to do if your policy already has become a MEC.
When Does a Policy Change to a MEC?
A percentage of your monthly or annual payment goes into the cash value component of a permanent life insurance policy. You can access it during your life through policy withdrawals or loans.
Every insurance company has its own set of rules and regulations regarding how much you can contribute to your policy’s cash value each year. And the IRS has its own set of rules and regulations as well.
If your payments toward your policy’s cash value surpass federal limits, your coverage is no longer typical life insurance. It transforms into a modified endowment contract (MEC). And this will have significant tax ramifications and limitations.
When your policy is modified into a MEC, you won’t be able to collect your cash value until you’re over 59 and a half years of age. However, you can access the cash value, but there will be a penalty.
It is impossible to change the status of a life insurance policy once it has been converted to a modified endowment contract. However, if a premium payment exceeds the seven-payment maximum, your insurance provider will most likely call you.
You can then ask for a refund if you want to keep your policy as life insurance, or you can accept having an MEC. But before accepting a MEC, speak with your agent or financial advisor.
A MEC contract is pretty much like a retirement annuity, as it guarantees annual or monthly payments over a lifetime. Plus, a MEC can also supplement your social security.
Many tax laws overlap between MECs and retirement annuities, including penalties for early withdrawals. Unlike retirement annuities, however, MECs provide recipients with a tax-free death benefit payout.
The IRS will deem your life insurance policy as a MEC if all the following criteria are met:
- Your policy was put into action after 6/20/1988.
- Your policy doesn’t pass a “7-pay test”, as stated in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).
- Your policy meets the Section 7702 definition of a “life insurance policy.”
Paradigm Life is a great place to continue if you want to learn more about modified endowment contracts.
Avoid Your Policy Becoming a MEC
The key to avoiding your life insurance becoming a MEC is to talk to your agent or insurance company. You need to get reassurance that your annual policy premiums do not exceed federal tax limitations.
If your policy is already a MEC, you won’t be able to reverse it. Yet, it still could be a valuable tool for retirement and estate planning. You just won’t be able to withdraw cash tax-free.
Thanks for checking out this post, and please take a look at our blog for helpful tips and advice.