Situation: Over the past several years a number of life insurance carriers and marketing organizations have been promoting the use of life insurance as a source of cash in retirement: accessing values when the market takes a down-turn on a tax-free basis. Since more economists believe that recession might be around the corner, now is a good time to brush-up on a tax rule that can cause unnecessary taxation.
Where lifetime access to cash values on a tax favored basis is important, care must be taken when funding a policy or making changes to policy benefits. Why? Because, excessive funding and some policy changes can cause the policy to be taxed as a Modified Endowment Contract (MEC). MECs are subject to certain unique tax rules. Specifically, lifetime distributions and loans from a MEC are treated as coming from gain first, subject to ordinary income tax. In addition, a penalty tax of 10 percent may be imposed.
Some planning techniques purposefully trigger MEC status at the inception of the contract and carrier illustrations will typically alert advisors and clients of this fact. In addition, MEC status can be inadvertently triggered by subsequent modifications to existing policies that are intended to address a client’s changing needs. Consequently, advisors should continually monitor changes to a client’s policy to avoid unintended application of MEC status.
Given the income tax consequences of MEC status it’s important that financial advisors have a working understanding of the MEC rules. This Counselor’s Corner will describe what causes a policy to become a MEC and how a MEC is taxed. In addition, we will discuss a retirement income technique currently being promoted as taking advantage of a loophole in the MEC rules which might be too good to be true.
Solution: Before we get into a discussion of what causes a policy to become a MEC, it’s helpful to know what transpired prior to its enactment that caused Congress to pass the MEC legislation. In the late 1970s, insurance companies began developing products that were flexible in nature and that could be used as investment vehicles. In particular, single-premium life insurance contracts became popular because investment gains inside the policy could be deferred while the owner was able to take principal-first, income tax-free distributions. Congress felt the need to establish controls. This resulted in the passage of three federal tax acts (TEFRA – 1982, DEFRA – 1984, and TAMRA – 1988) designed with the intent to ensure that the income tax advantages of life insurance were not abused. The third act, TAMRA, established the MEC rules.
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