What is the penalty tax on distributions taken from a MEC?

Modified Endowment Contract - "MEC"A modified endowment contract (MEC) is a life insurance policy (including Indexed Universal Life) that failscertain testsand is thus caused to be

What is the penalty tax on distributions taken from a MEC?

Modified Endowment Contract - "MEC"

A modified endowment contract (MEC) is a life insurance policy (including Indexed Universal Life) that failscertain testsand is thus caused to be treated less favorablyfor income tax purposes.

Changes to the tax law in 1988 resulted in certain life insurance policies that were deemed to be funded too rapidly being classified as modified endowment contracts (MECs). Prior to enactment of the MEC rules, it was possible to place large amounts of cash into a single premium life insurance policy where, if the money were needed, the cash value was accessible to the policy owner through tax-free lifetime loans. These policies were being used in place of other investment vehicles, the earnings on which were subject to income tax. MEC policies still maintainthe inside buildup growth on a tax-deferred basis, and at death the proceeds pass tax free to the beneficiary.

Under the current law, money taken from a MEC in the form of policy or premium loans, partial surrenders, assignments, pledges, withdrawals, or loans secured by the policy are subject to income tax and possibly penalties. While a MEC provides a death benefit as with traditional cash value life insurance, it has been stripped of a major feature: tax-free access to cash values.

In a general sense, the "corridor rule" states that in order for any life insurance policy to avoid being classified as a MEC, there must be a "corridor" of difference in dollar value between thedeath benefitand the cash value of the policy. All single-premium policies are now classified as MECs. Flexible-premium policies must pass the Seven-Pay Test in order to avoid MEC status. This test caps the amount of premium that can be paid into a flexible-premium policy over a period of seven years.

Each policy that is now issued will have its own MEC premium limit that is based on several factors, including the age of the policy owner and the face amount of the policy. Any premium paid into the policy in excess of this limit will result in reclassification of the policy as a MEC. However, the unused cap space within this limit is cumulative. For example, if the MEC limit for a policy is $5,784 the first year and $4,000 of premium is paid into the policy, then the excess $1,784 of unpaid premium is carried over to the premium limit for the second year.

This limitation expires after seven years, as long as there are no material changes, such as an increase in death benefit. Any material change will effectively restart the Seven-Year Test. A decrease in the death benefit will not restart the test, but it may result in the policy being immediately classified as a MEC for other reasons. Once a policy has been classified as a MEC, it cannot regain its former tax advantages under any circumstances. The MEC classification is irrevocable.

Policies entered into before June 21, 1988, are not subject to the MEC rules clause unless they undergo a material change. All policies entered into after June 20, 1988, and any policy, whenever issued, that undergoes a material change after June 20, 1988, will be tested under the MEC classification rules.

Once classified as a MEC, a policy remains a MEC. The policy status doesn't change even if the policy is changed, adjusted, or reconfigured as a policy that would not otherwise be considered a MEC. A policy received in exchange for a MEC is also considered a MEC, even if the policy received under the exchange wouldn't otherwise be considered a MEC.

The 7-Pay Test Determines MEC Status. Mandated by government, the test used to determine if a policy is a MEC is called the 7-pay test. The 7-pay test has nothing to do with the actual number of premium payments. Instead, it is a limitation on the total amount you can pay into your policy in the first seven years of its existence. The test is designed to discourage premium schedules that would result in a paid-up policy before the end of a seven-year period.

The 7-pay test examines the cumulative amount paid under a contract during the first seven policy years. This amount is compared to the sum of the net level premiums that would have been paid on a guaranteed seven-year pay whole life policy providing the same death benefit.

The 7-pay test must be applied in three situations:

To initially test all policies entered into after June 20, 1988

To re-test policies entered into after June 20, 1988, if the death benefit is reduced within the first seven contract years

To test or re-test any policy (regardless of date entered into) that undergoes a material change in future benefits after June 20, 1988

The net level premium amount used in the calculation for the 7-pay test is based on certain statutory assumptions regarding interest, mortality, and expenses. Your insurance company should inform you of the 7-pay limitations and how they specifically relate to your policy. Many insurance companies offer assistance in tracking policy premiums to avoid MEC classification.

If you somehow manage to pay premiums in excess of the guideline amounts for your policy, the excess amount plus any accrued interest can be returned to you by the insurance company and MEC classification avoided. The return of the excess premium must occur within 60 days after the end of the contract year.

The MEC rules trigger tax and a penalty when the cash value is accessed through lifetime loans, withdrawals, or through use of the cash value as collateral. If you have a policy that is classified as a MEC and you never access your cash value through a lifetime loan or withdrawal, you won't be subject to the tax and penalty.

MEC's are subject to tax on the "last-in, first-out" (LIFO) method. This is much like the income taxation of an annuity. Withdrawals, borrowings, or use of cash value as collateral from a policy classified as a MEC results in the immediate taxation of all or a portion of policy gains. Unlike withdrawals from a non-MEC policy, which are treated as a return of premium up to the amount of the policy basis, withdrawals from a MEC are treated as coming first from income (earnings) on the policy. The amount of the withdrawal(to the extent of policy gains) must be included in your gross income and is taxed at the ordinary income-tax rates. Policy gain equals the difference between the cash value and the net investment in the policy (policy basis).

Let's say you bought a policy with a single premium payment of $100,000 (causing it to be classified as a MEC). The policy now has a cash value of $125,000 (policy gain is $25,000). You take out a policy loan for $50,000. You must include the amount of the policy gain of $25,000 in your gross income and this gain will be subject to income tax at the ordinary income-tax rates. With a non-MEC policy, you would be able to withdraw up to your original $100,000 policy basis before you would be subject to income tax on the withdrawal (and loans would not be subject to income tax, even if the loan amount exceeded your policy basis).

In addition to paying regular income tax on the amount of the policy gain, any taxable withdrawals, borrowings, or uses of cash values as collateral before age 59½ are also subject to a 10% penalty tax. This penalty tax only applies to the portion of the distribution or loan that is included in gross income.

Continuing the example above, let's say that you are 58 years old and healthy when you take out the MEC policy loan. In addition to regular income tax, you must also pay a penalty of 10% on the $25,000.

Funds withdrawn as a result of disability, after age 59½, or over a period related to the policy owner's lifetime or the joint lifetime of the policy owner and the beneficiary as part of a series of substantially equal periodic payments made not less frequently than annually are not subject to the penalty tax.

Nevertheless, if you don't expect to need to access the money during your lifetime and only want to transfer it to the next generation, a MEC can make sense. The typical buyer of a policy classified as a MEC is an investment-oriented individual who probably won't need extra lifetime retirement income. The tax and penalty are triggered only if lifetime distributions occur. If there is no cash value access, then there is no tax or penalty applied. A MEC can be a tax-deferred savings vehicle that provides some life insurance. When you die, the death benefit passes to your beneficiary, generally free of income tax. This allows a transfer of wealth that may be taxable under other methods. (Back to IUL Table of Contents)

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