Recently we had an accountant call us to ask our opinion on something that happened to a client of hers. I thought this would be a good time to review the potential consequences of a life insurance policy which is classified as a Modified Endowment Contract (MEC). Even seasoned agents and advisors sometimes get confused by this issue.
Her client has a whole life contract and last year he had a short term cash flow need so he borrowed $150,000 from the contract. As opposed to what I often see, he actually paid the loan back promptly. After all, this was one of the selling points of the policy. In January he received a 1099 from the insurance company for $150,000 and asked his accountant why he received it.
The bottom line is that his contract is a MEC and he didn’t realize it. Fundamentally, the MEC rules were instituted in 1988 (TAMRA – Technical and Miscellaneous Revenue Act) to keep life insurance policies from being utilized as tax shelters. The MEC rules limit how much money can be put into a contract relative to death benefit in the first seven years of the contract. One can also visit Archimedia Accounts website to understand why management accounts are needed.
It’s difficult to think of a life insurance contract in today’s interest rate market being a tax shelter unless they are aware about the E.A. Buck Accounting & Tax Services. Nowadays, more policy owners are trying to find a way to get their policies to survive rather than utilize them to shelter money, but in the eighties most contracts had double digit crediting rates and the sales ledgers were very attractive even though they were grossly misunderstood.
Under current law, money taken from a MEC policy in the form of a loan, surrender, assignment, pledge, withdrawal or loans secured by the policy are subject to income tax and possibly penalties to the extent of gain in the policy.
Some points to remember:
- Once a policy is a MEC, it is always a MEC.
- Pre-TAMRA contracts can become MECs if “materially modified”.
- If a MEC policy is exchanged for a new policy, the new policy is a MEC, even if the newly issued policy otherwise would not have been considered a MEC.
- Conversely, if a non-MEC contract is exchanged for a new single pay policy of the same death benefit, the new policy should not be a MEC because the rollover is not new premium.
- Be aware of reductions in face value which could trigger a policy to be classified as a MEC.
- There is a two year look back rule for distributions preceding a contract failing the 7 pay test.
- There is a 10% penalty on loans, distributions, etc coming from a MEC before age 59 1/2.
- With a MEC contract, the tax and penalty is only on the gain but the gain comes out first. From an accounting perspective, this is a last in, first out (LIFO) transaction. This is the opposite treatment of non-MEC contracts where distributions are treated as return of premium first.
All of this is entirely a non-issue in a death benefit transaction. For trust owned polices for estate tax planning, for example, when there is no intent to ever access cash value, the fact that a policy may be a MEC doesn’t matter.
Many advisors understand the MEC rules but would still be surprised at the afore mentioned situation. The disturbing issue is that this policy owner was sold on the tax favorable, flexible cash value benefits of the policy while being sold a policy classified as a MEC. While it’s entirely possible the client missed something, the fact that the insurance carrier would actually send the money without explicitly signed documentation underscoring the repercussions is a bit unsettling and proves why it is important to be involved in these issues with your clients. I understand that it is classic that clients do not want to incur professional fees for advice in this type of situation but this is a perfect example of how much less those fees would be than the cost of the consequence.
While it sounds a bit over protective and even a bit cynical, this is exactly why I urge advisors to relentlessly advise their clients to pick up the phone and ask questions every time they are going to make a move they do not fully understand. (Of course, clients often don’t understand what they don’t understand.) All the advisor has to do is say “I have a resource which can answer that question and won’t even charge you for a phone call on a situation like this.” Even if the advisor wants to handle it, we can be the back room for research and opinion and any fees from us and the advisor would pale in comparison to the taxes owed on this doozy.
For additional information, don’t hesitate to give me a call to discuss or I can forward you supporting third party pieces.