Key takeaways. A modified endowment contract (MEC) is a cash value life insurance policy that gets stripped of many tax benefits. The seven-pay test determines if the policy qualifies as an MEC. MECs ended a popular way to shelter money from taxes by borrowing from insurance policies whose cash value grew too quickly.
- 1 What happens when a life insurance policy becomes a MEC?
- 2 Is a modified endowment contract good?
- 3 How are MEC withdrawals taxed?
- 4 What happens if a life insurance policy failed the 7-pay test?
- 5 Is a partial withdrawal from life insurance taxable?
- 6 Does a MEC automatically lapse?
- 7 What are the disadvantages of MEC?
- 8 Is a MEC a life insurance?
- 9 What is a MEC limit?
- 10 What type of life policy has a death benefit that adjusts periodically?
- 11 What is considered a limited pay life policy?
- 12 Which type of life insurance policy is best suited for paying off?
- 13 Can you borrow from a MEC?
- 14 How are MEC policy loans taxed?
- 15 Can you Overfund a whole life policy?
What happens when a life insurance policy becomes a MEC?
When a permanent life insurance policy becomes an MEC, you can no longer make tax-free withdrawals from the cash value. Before age 59 ½ you’ll pay taxes and a 10% fee to access your money. After age 59 ½ you’ll still pay taxes, but with no additional penalty.
Is a modified endowment contract good?
If your main financial goal is to pass on the most tax-free wealth possible to your family, a Modified Endowment Contract can be a great estate planning tool. Compared to other savings vehicles like CDs or money market accounts, MECs typically earn a higher interest rate.
How are MEC withdrawals taxed?
Tax Implications of an MEC Unlike traditional life insurance policies, taxes on gains are regular income for MEC withdrawals under last-in-first-out (LIFO) accounting methodology. However, the cost basis within the MEC and withdrawals is not subject to taxation.
What happens if a life insurance policy failed the 7-pay test?
It is possible that a contract that requires seven level annual premiums will fail the 7-pay test because the statutory net level premium will be less than the actual premium paid. Once a policy has failed the 7-pay test, it becomes a MEC and remains a MEC for the life of the contract.
Is a partial withdrawal from life insurance taxable?
When You Make a Partial Withdrawal From the Cash Value of Permanent Insurance. While you’re still living, you can make a partial withdrawal from the cash value portion of your policy, and this amount is not taxable.
Does a MEC automatically lapse?
Once a flexible premium cash value life insurance policy becomes classified as an MEC, it immediately loses its former tax benefits, and this transformation is irreversible. A MEC cannot become a life insurance policy ever again, regardless of circumstances.
What are the disadvantages of MEC?
There are some cons of a MEC that you will want to avoid if your policy is not currently considered a Modified Endowment Contract. If your policy becomes a MEC, this advantage (FIFO) goes away and the policy is treated like a typical retirement vehicle, such as a non qualified annuity.
Is a MEC a life insurance?
Key takeaways. A modified endowment contract (MEC) is a cash value life insurance policy that gets stripped of many tax benefits. The seven-pay test determines if the policy qualifies as an MEC.
What is a MEC limit?
This is called the 7-pay limit or MEC limit, and is based on rules established by the Internal Revenue Code, setting the maximum amount of premium that can be paid into the contract during the first seven years from the date of issue in order to avoid MEC status.
What type of life policy has a death benefit that adjusts periodically?
A more flexible version of variable survivorship life insurance called “variable universal survivorship life insurance ” allows the policyholder to adjust the policy’s premiums and death benefit during the policy’s life.
What is considered a limited pay life policy?
Limited pay life insurance is for an individual who owns a whole life insurance policy but chooses to pay for the total cost of their premiums for a limited number of years. With the limited pay life insurance option, you pay premiums in the first 10, 15, or 20 years of ownership, but the benefits last a lifetime.
Which type of life insurance policy is best suited for paying off?
A permanent policy’s cash value grows over time and can be used to pay premiums or take out a loan from the insurer. Since permanent life insurance policies have much higher rates than term policies, and most financial obligations go away over time, term life insurance is typically the better option for most people.
Can you borrow from a MEC?
Any loans or withdrawals from an MEC are taxed on a last-in-first-out basis (LIFO) instead of FIFO. Therefore, any taxable gain that comes out of the contract is reported before the nontaxable return of principal.
How are MEC policy loans taxed?
Generally, policy loans from non-MECs are not subject to income tax. But any withdrawals (including loans and partial or full surrenders) taken from the cash value of a MEC are treated as coming from earnings first and are taxed as ordinary income to the extent the policy”s cash value exceeds your basis.
Can you Overfund a whole life policy?
Permanent life insurance policies, such as whole life insurance or universal life insurance, have a cash value component. So, by overfunding your policy, you contribute more to the cash value. However, if you pay more than the minimum amount required, the cash value of your policy typically grows.