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A Complete Guide to the Modified Endowment Contract (MEC)



What is a modified capital agreement?

A modified capital agreement (MEC) is a life insurance policy that fails the 7-salary test laid down in the Tax and Miscellaneous Revenue Act of 1988 (TAMRA). If this test failed, the life insurance policy was reclassified, which comes with several changes in the taxation of the insurance contract. <! – ->

It is important to understand that while they differ from ordinary life insurance policies under US federal tax law, the MEC is still a form of insurance contract. They continue to pay a death benefit. They will continue to accumulate cash value. If the insurance is still within the premium payment period, the policyholders will continue to pay premiums to the insurance.

It is also worth noting that only life expectancy and universal life insurance can become modified capital agreements. So if you own life insurance, you do not have to worry about an MEC.

You should also know that the modified capital agreement is not the same as a traditional life insurance contract. The latter is an insurance policy that became obsolete in the United States during the adoption of tax rules in the early 1980s which was a precursor to TAMRA. <! – ->

Understanding of the 7 salary test and why there is the

7 salary test is a premium limit placed on a life insurance policy based on the total death benefit for the insurance. This means that the 7-salary limit is linked to the prevailing death benefit for a life insurance with cash value.

The specific MEC rule limits the sum of the net level premiums from exceeding the amount needed to guarantee all future benefits of the insurance paid during seven contract years. This basically means that the 7-salary limit prevents a life insurance policy from being paid before the insurance year 7.

So, for example, let's say you buy a life insurance policy that has a 7-salary premium of $ 50,000. The specific calculation that reached these $ 50,000 involved information about the amount of death, the guaranteed rate of accumulation and the mortality costs for the policy. Note that I omitted administrative costs. Insurers can only bear the raw insurance cost of providing a death benefit in the 7-wage test. they cannot include additional costs associated with normal business operations. <! – ->

As long as your annual premium does not exceed $ 50,000 during the first seven contract years, you will not violate the 7 -pay test and create a modified capital agreement. This amount is cumulative, so if you make a premium payment of $ 25,000 during the first year of the contract, you can technically make a payment of up to $ 75,000 in year two without creating an MEC. 19659011] It is also important to know that since the MEC rules prevent guaranteed paid-in insurance before year seven, life insurance with a premium will be automatically modified capital agreements. So if you own a premium policy, you also own an MEC.

To understand why the MEC rules exist, we must go back to the 1970s when a decisive change in the life insurance industry took place. Until this time, very few life insurance policies allowed policyholders to pay significantly more premiums than the required premium for a certain death benefit.

But during the 1970s, life insurance companies came up with a new innovation, universal life insurance. . This new product has several features never seen before, one of which was a flexible premium that in theory could be as high as the insurance owner wanted. This opened the door to take advantage of the very fiscally favorable aspect of life insurance cash value, and it was particularly prominent given the high income tax rates prevailing at the time. .jpg "width =" 800 "height =" 354 "data-lazy-src =" https://upload.wikimedia.org/wikipedia/commons/thumb/8/8c/Historical_Marginal_Tax_Rate_for_Highest_and_Lowest_Income_Earners.jpg/800px-H_al___J_A__Ex_ File: Historical Marginal Tax Rate for Highest and Lowest Income Earners.jpg ” width=”800″ height=”354″/>

Source: Taxfoundation.org

Universal life insurance created a mechanism for Americans (especially wealthy Americans) to accommodate significant cash in life insurance and use its tax evasion nature to prevent significant tax payments to the federal government.It was a tax home that did not require complicated bank accounts on land.

During the early years of universal life insurance, Americans could literally buy insurance with as small a death benefit as the life insurance company allowed, make a premium payment many times greater than the death benefit and secure a tax free account with almost no insurance costs. Of course, this was not the purpose of life insurance, and Congress tried to close the loophole. It was not until the early 1980s that rules were established that determined what was and what was not a life insurance contract. Congress then reconsidered these rules in the late 1980s to make additional demands to maintain good life insurance status. This late 80's audit established the 7-salary test and Modified Endowment Contracts, under TAMRA.

So the Modified Endowment Contract exists as a way to prevent life insurance from being used solely as a tax protection. While people still use cash life insurance as a way to collect tax deferred and potentially tax-free assets, the MEC rules make it more complicated and less appealing than it once was.

Who is responsible for ensuring compliance with Federal Tax Law boundaries?

The insurance company is responsible for checking an insurance for compliance with the 7-salary test. Almost all life insurers perform the calculation when they receive a premium payment on a cash value life insurance. If the carrier considers that all or part of the payment exceeds premiums per 7-salary limit, it will immediately notify the policyholder that he / she has violated the 7-salary limit for his / her insurance. <! – ->

Insurance companies report MEC classification for all insurances that do not meet the test to the IRS.

Material change: MEC violation after 7 years

While some people believe that Modified Endowment Contracts only occur in the event of a single premium life insurance or violation of the 7-salary test during the first 7 years of insurance, this is a misunderstanding of the rules.

Both whole life insurance and universal life insurance can break the MEC test and become Modified Endowment Contracts during insurance year 8+. This can happen when the insurance undergoes a significant change.

In general, a significant change occurs when a policyholder adds a feature to a life insurance policy or changes the policyholder. With each material change, a new 7-year clock begins. <! – ->

Increasing the death benefit is considered an additional function. Many cash value policies use features that create increasing death benefits, which causes a continuation of the MEC 7-year period. For this reason, lifetime and universal life policyholders using insurance that has an increasing death benefit will have insurance covered by premium limits introduced by the Modified Endowment Contract rules indefinitely. ]

What happens when an insurance becomes a moderate capital agreement?

If a life insurance policy becomes a modified capital agreement, the tax rules for the cash value of the insurance change dramatically.

Changing these rules has almost no effect on the death benefit of politics. MECs will still pay an income tax-free death benefit to the recipient of the policy.

Tax consequences of MEC status

A life insurance contract that fails the 7-wage test and becomes a modified capital contract loses several tax benefits regarding the cash value of the contract. <! – ->

Instead of using the first-in first-out (FIFO) accounting principle, an MEC will use last-in-last-out (LIFO). This means that when the policyholder removes money from the insurance, he / she must first withdraw any profits achieved through the agreement before taking a non-taxable cost base. This rule on withdrawals applies both to partial transfers and to insurance loans. Making a collateral assignment with an MEC (ie using the contract's cash value as pledged assets for a bank loan) is also counted as a taxable distribution.

The contract owner also faces a similar penalty that exists in pension accounts where you take money from the contract before the age of 59.5 incurs an early distribution of excise tax of 10%.

It is important to understand that ALL distributions from an MEC are counted as taxable income provided that there is still profit in the policy. There is a subtle but important technical consequence of taking out an insurance loan with an MEC. If the MEC policyholder chooses to have the loan interest added to the accumulated loan amount each year (a very common practice for loans taken out against traditional life insurance), this accumulated loan interest will also be counted as a distribution from the MEC and potentially create additional taxable income.

For example, suppose you own a contract that is under MEC status. The insurance has $ 100,000 in cash value and you paid a total of $ 50,000 in premiums to the insurance. You decide to take out a $ 10,000 loan against the policy. The annual loan interest rate on loans for this policy is 5%.

This $ 10,000 loan will increase your taxable income for the year by $ 10,000. This happens because you have $ 50,000 in policy winnings and you must remove this first before you can touch the $ 50,000 base you have by paying premiums. For one year after you take out the loan, and provided you do not make any loan repayments, you will collect a total of $ 500 in interest.

Like all insurance loans, you have the option to either pay these $ 500 or let it add to your current loan balance. If you choose to add $ 500 to your loan balance, this creates an additional $ 500 breakdown from the policy, giving you an additional $ 500 of taxable income.

One year later, provided you do not repay the accumulated loan, you have accrued an additional $ 525 in interest. If you choose to add this to your loan balance again, you will add $ 525 in taxable income that year.

This interest rate implication is a potentially small but often annoying meaning of owning a Modified Endowment Contract.

The last important tax consequence for understanding MECs is that you cannot change an insurance under MEC status to a new life insurance without immediately creating a new MEC. This rule exists to prevent people from intentionally violating the 7-wage test and then purchasing a new life insurance policy via the 1035 foreign exchange tax provision to avoid the consequences of breaking the test. So if your current insurance is an MEC and you transfer it to a new insurance via the 1035 exchange, the new insurance is automatically a MEC.

While the MEC dramatically changes the tax consequences of a life insurance contract's cash value, they do nothing for the taxable death benefit rules. This means that a modified capital agreement will still pay a death benefit that your recipient received income tax-free.

Are they ever good?

While most people have a very negative view of modified capital agreements, there are some people who intentionally create them. The vast majority of Americans are probably best off trying to avoid MEC status in their life insurance policies. But there are some situations that can use an MEC with positive results.

The tax rate for an MEC is similar to unqualified annuities. Although an MEC may not necessarily provide the guaranteed income annuities can provide, there are times when people use them instead of regular annuities when they think the MEC will provide a higher return on cash value or because they want the additional deadly benefit it creates. .

A modified capital agreement can also sometimes work well as a tool for property planning purposes. Because MEC status has virtually no negative tax consequences for the death benefit, some people use it as a way to provide liquidity on death or to increase the value of their savings that they intend to pass on to loved ones.

There are several considerations to consider when a MEC option is on the table, and in most cases it will probably not be the best. However, you should not immediately rule it out just because most people say that MECs are bad.

Can a modified capital agreement be reversed?

Yes, there is a process to reverse MEC status if you find that you are violating the 7-Wage Test. Many insurance companies make this process almost automatic in the sense that they will try to prevent you from doing so before you technically commit the crime.

As already mentioned, life insurance companies check life insurance policies to follow the 7-salary test. with each prize received. If your payment seems to violate the test, they will notify you in an attempt to prevent you from accidentally creating a modified capital agreement. But even if you ignore this warning, you have technically seen up to 60 days after the end of the insurance year when the breach took place to request that the insurance company repay the premium amount that caused the breach.

What's more, there is a process that the tax law spells to reverse the MEC status of a policy that exceeds this timeline (ie 60 days after the end of the anniversary of the violation), but understand that insurers are not always willing to implement it

The law allows an insurance company to undergo a lengthy process to reverse MEC status and pay a small fee to reverse the classification. The law allows this, but do not expect your life insurance company to volunteer this service if you get your insurance to become a modified capital agreement.


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