Want to Access Policy Cash Value? MEC Limits Become More Lenient

Situation: Over the years a number of life insurance carriers and marketing organizations have promoted 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 and potentially restoring the borrowed amount when the market is up. Given the political and tax environment this strategy may be even more attractive today.

Specifically, tax-free and tax-deferred saving options are especially attractive for high tax-bracket taxpayers. The chance that high bracket taxpayers will see an increase in their tax bracket in the near future appears certain given the deficit and the current political environment. Second, life insurance as a savings option became more attractive because of legislative modifications to Section 7702 of the Internal Revenue Code which occurred a couple years ago.

However, 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, even with the changes to Section 7702, 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, it’s also important that financial advisors understand that 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 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 cause 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 under 7702A.

What Changed Recently in Section IRC 7702 and How Does It Impact MEC?

On December 27, 2020, the President signed into law legislation that included changes to the interest rate assumptions used in IRC §7702 – the Internal Revenue Code provision that defines how much premium can be contributed to a life insurance policy. The minimum rates of 6% and 4% had not changed since its enactment in 1984. Of course, interest rates had declined to near historic low levels. To address this situation the legislation changed the fixed rate assumptions with a dynamic interest rate model effective beginning 2022, thus allowing interest rates to float over time in keeping with prevailing market rates. Beginning in 2021 the legislation permitted carriers to lower their assumptions to 2%. As a result of this modification to Section 7702 more premium could be paid into a contract and/or more cash value could accumulate relative to the death benefit without the policy becoming a MEC resulting in better IRR on life insurance policy cash value accumulations.

What is A Modified Endowment Contract? What Triggers MEC Status?

A modified endowment contract (MEC) is a life insurance contract:

• entered into or materially changed after June 21, 1988, and
• which fails the “seven-pay test.” ¹

A policy fails the seven-pay test if the cumulative premiums paid during the first seven years of the contract (or the first seven years after a material change) exceed the amount needed to provide a paid-up policy based on seven statutorily defined level annual premiums.² Essentially, the 7-pay test limits the overpayment of premiums by requiring a minimum level of insurance face amount per premium dollar. A common example of a MEC is a single premium policy. However, it’s important to note that a policy can fail the 7-pay premium test later if premiums increase or are paid in in irregular amount.

Furthermore, it is important to note that a policy that originally satisfied the 7-pay test may nonetheless become a MEC if it undergoes a material change or face amount reduction, as discussed below.

Grandfathered Contracts Can Become MECs. A policy, entered into before June 21, 1988, is not subject to the 7-pay test unless a material change is made to the contract. When a grandfathered policy is exchanged for a new policy, a material change has occurred and the new policy must be tested for 7-pay compliance. The exchange of a grandfathered policy does not automatically trigger MEC status, but rather triggers the 7-pay test.

Material Changes. When a material change is made in the benefits under the insurance contract that was not reflected in any previous 7-pay test, a 7-pay test must be applied as if a new contract were entered into on the date on which the material change took effect. The new 7-pay premium is adjusted to take into consideration the contract’s existing cash surrender value as of the date of the change.

A material change generally includes:

• An increase in the policy death benefit (with some exceptions);
• Any increase or addition of a qualified additional benefit/rider (i.e., guaranteed insurability, disability waiver).
• Term life conversions to permanent coverage; and
• Exchanges of one policy for another, whether taxable or tax-free under IRC § 1035.
• Some increases not considered a material change include:
• Increases due to the necessity to fund the lowest possible death benefit and qualified benefits in the first seven years.
• Increases due to the crediting of interest or other earnings, including dividends.
• Cost-of-living increases based on a broad-based index.
• Adding a qualified long-term care insurance rider.
• Changes due to the financial insolvency of the insurer.

Death Benefit Reductions. Where there is a scheduled or an unscheduled reduction in the death benefit within the first seven contract years (or the first seven years after a material change), the 7-pay test must be recalculated as if the contract had originally been issued at the reduced death benefit level.³ If the policy fails the recalculated 7-pay test, MEC income-first taxation applies.⁴ For example, assume a policy is acquired where the MEC premium limit is $30,000 and annual premiums of $25,000 are paid for 6-years. In the year six $100,000 is withdrawn, which reduces the face where the 7-pay annual premium is $23,000. This causes the policy to become a MEC subjecting the gain in the withdrawal to be subject to tax (and possibly 10% penalty).

A special rule applies to survivorship policies. In the case of a survivorship policy issued on or after September 14, 1989, a new 7-pay test based on the initial premium and the reduced death benefit is required even if the reduction occurs after the first seven policy years.

Policy Exchanges-Once a MEC Always a MEC. A MEC cannot be washed clean of MEC status by means of an IRC § 1035 exchange. A contract received in exchange for a MEC will also be a MEC. Once a policy becomes a MEC it remains a MEC for the life of the contract. Even if the MEC policy is exchanged for a new policy the new policy will be a MEC.

A properly planned exchange of a non-MEC with no new money will not create a MEC since the cash value existing on the day of the exchange is not treated as new premium. The 7-pay test must be applied, but the new policy will always pass the test as long as the death benefit remains the same and no additional premiums are paid into the new policy.

In contrast, an exchange with new money may create a MEC because the 7-pay test must be reapplied. Similarly, when a policy is less than seven years old and an IRC § 1035 exchange is made, and the acquired policy has a reduced face amount relative to the exchanged policy, the 7-pay test must be reapplied retroactively over the 7-pay period. If any premium paid during that period exceeds the new adjusted 7-pay premium, the acquired policy will be a MEC.

Safety Valve – Return of Premiums. If a policy would become a MEC because of the payment of premiums in excess of the cumulative MEC premium, MEC status can be avoided if the insurer returns the excess premium paid plus interest within 60-days of the end of the year in which the excess occurs.⁵

What Are the Tax Consequences of A MEC?

Tax on Lifetime Distributions. Lifetime distributions from a MEC are taxed differently than distributions from non-MEC policies. Distributions are taxed as ordinary income when received to the extent that there is a gain in the contract.⁶ In other words, distributions from a MEC contract are taxed as income first and recovery of basis second until all gain has been withdrawn or borrowed. This is similar to the taxation of a deferred annuity.

Amounts treated as income-first distributions include:

• Policy loans, whether used for paying premiums or for other purposes.
• Loans secured by the policy.
• Interest accrued on a policy loan.
• Policy assignments (i.e., change of policy ownership, collateral assignment of policy).

Amounts not treated as income-first distributions include:

• Dividends retained by the carrier to pay premiums on the contract.
• Dividends used to purchase paid-up additions.
• Term insurance or other qualified additional benefits.
• Surrender of paid-up additions to pay premiums.

Penalty Tax. Unless the taxpayer is at least 59½ years old, has become disabled, or the distribution is part of a series of substantially equal periodic payments over the life expectancy of the taxpayer or the taxpayer and his beneficiary, any taxable distribution from a MEC will be subject to a 10% penalty.⁷

Look Back. A look back rule applies MEC taxation to any distribution in the two years before the policy failed the 7-pay test in addition to MEC taxation in the year it fails and all future years where there is a distribution.⁸          

Tax Otherwise Same as Non-MEC. MEC and non-MEC policies are otherwise taxed the same. Specifically, the cash value inside a life insurance policy and death benefit received by beneficiaries is generally income tax-free.

Retirement Income Strategy: Clever Use of MEC Loophole or Too Good To Be True Illustration “Illusion”.

This author has reviewed many concepts where life insurance is acquired using distributions from qualified retirement accounts. In most cases the objective is to create an income tax-free legacy for heirs instead of a tax bill. Now that it is also possible to add a long-term care or chronic illness rider to life insurance, clients are expressing greater interest in these techniques.

Most of the qualified plan distribution strategies are structured to provide the maximum amount of death benefit for a minimum premium amount to create a death benefit legacy for heirs so MEC is rarely an issue.⁹ However, one concept promoted by a couple of carriers utilizes the policy cash value to create an income tax-free retirement income for the retirement plan participant utilizing a minimum face non-MEC policy structure. While this strategy may comply with the letter of the MEC legislation, small changes in the illustration assumptions put the policy at risk of lapse with significant tax recognition. Because of the risks associated with this concept this author does not recommend its use.¹⁰ So what is the structure of this strategy you ask?

The strategy starts with a qualified plan participant or IRA owner taking taxable distributions from his/her account and using the full distribution to pay premiums on a life insurance policy. The policy is structured as an increasing “option B” minimum non-MEC face using the GPT (guideline premium test) definition.¹¹ In year 2 the policy owner takes a policy loan to pay the tax due on the first year plan distribution in addition to taking a taxable qualified plan distribution and using the full amount to pay premiums. This premium payment structure is also used for policy year 3.

Starting in year 4 no qualified plan distributions or policy premiums are paid. However, in year 4 a policy loan for tax due on the third-year plan distribution is taken followed by a death benefit option change from “B” (increasing) to “A” (level). Following the death benefit option change in year 4 the policy face amount is reduced to the lowest amount possible. Beginning in year 5 income tax-free policy distributions structured as loans are made to the insured’s age 100. Eventually, at the insured’s death proceeds are paid to the beneficiary income tax-free.

Example. A male age 60 standard risk buys a $1,295,968 index universal life policy from a carrier permitting variable loan interest rate. Three annual premiums of $100,000 are paid with funds acquired from his IRA. In policy years 2, 3 and 4 $30,000 is borrowed from the policy to pay the tax due on the IRA distributions. In policy year 4 the death benefit option is changed from increasing to level when the death benefit is $1,508,758, followed by a face amount reduction to $261,090. Beginning in year 5, and continuing for the next 35 years, annual loans of $24,000 are received income tax-free by the insured. 

For MEC purposes a reduction of death benefit in the first 7 years usually causes the 7-pay test to be recalculated as if the contract had originally been issued at the reduced death benefit level. In our example, the $100,000 premium clearly exceeds the 7-pay limit for a $261,000 face amount policy, but MEC taxation is not triggered. The reason MEC taxation is avoided is because prior to the face amount reduction the death benefit change from “B” to “A” triggered a material change. A material change in the first 7-years followed by a death benefit reduction requires a recomputation of the 7-pay test back to the date of the material change, rather than the date of the policy issue, even though the periods overlap. Consequently, the policy distributions are not subject to MEC taxation.¹²

While the series of steps utilized by this strategy may comply with the letter of the law; the structure creates significant risk of policy lapse if policy crediting rates (or loan interest spread) actually received is less than the rate assumed in the illustration. In fact, in the example described above a minor decrease in crediting rate caused the policy to lapse prior to life expectancy. Furthermore, a policy owner cannot contribute additional premiums to “rescue” the policy because the GPT definition limits the amount of premium a carrier can accept. A lapse of the policy will result in recognition of all the policy gain as ordinary income.

In Summary: MEC rules are designed to limit the tax advantages of heavily funded and single-pay life insurance contracts. Nevertheless, MEC contracts still have a useful place in the world of life insurance. Owners of MEC contracts can still benefit from the tax-deferred cash value build-up and income tax-free death benefits of life insurance (under IRC § 101(a)). They just can’t access cash values without incurring ordinary income tax.