In addition to providing a death benefit for your beneficiaries, permanent life insurance policies allow you to build tax-advantaged cash value you can tap into while living. You can grow this cash balance faster by contributing additional premiums to your policy.
However, if you contribute too much to your policy too quickly, you risk turning it into a modified endowment contract (MEC), which could result in losing those tax advantages. Here’s a comprehensive look at MECs, including how a life insurance policy becomes one and the potential tax implications.
Understanding Cash Value Life Insurance
To understand MECs, you first need to understand how cash value life insurance normally works.
Unlike term insurance, which only provides a death benefit, permanent insurance policies such as whole or universal life build a cash balance. A portion of each premium you pay covers the death benefit, and another portion goes into an account that accrues a cash balance.
That cash balance grows tax-deferred and provides some tax advantages. For instance, you can borrow against it, and as long as you pay it back, the loan usually isn’t taxed. Additionally, withdrawals from your policy aren’t taxed up to the amount of premiums you’ve paid (known as the principal). Any withdrawals you take come first from the principal and then the growth.
For example, assume you have a cash balance of $25,000 and have paid a total of $20,000 in premiums. If you withdraw $10,000, it comes entirely from your principal balance, so no taxable earnings are withdrawn.
How a Modified Endowment Contract Works
Because of the tax advantages cash value life insurance provides, limits are set on the amount of additional premiums you can pay into a policy. If you overfund the policy, it’s considered a savings vehicle rather than primarily life insurance and becomes a modified endowment contract.
Specifically, your life insurance policy becomes an MEC if:
- You secured the policy on or after June 20, 1988.
- You fail the “seven-pay test,” which considers how much you’ve paid into a policy within the first seven years. If at any point you’ve paid more than what’s required to fully fund the policy during that time, you fail the test. Once you fail the seven-pay test, you can’t reverse it. Your policy stays an MEC for the remainder of the time your contract is in force.
Tax Implications of MECs
MECs are taxed differently than life insurance policies. Unlike a standard life insurance contract, money you withdraw from an MEC comes first from your earnings and then your principal. These earnings are included in your taxable income. In addition, a policy loan is treated as a withdrawal, and the gains are taxable.
If you aren’t at least 59½ years old, withdrawn earnings are also subject to an additional 10% early withdrawal penalty.
Although MECs aren’t taxed as favorably as ordinary life insurance contracts, classification as a modified endowment contract doesn’t affect your death benefit, only the cash value. Your beneficiaries will still receive the policy’s death benefit without taxes. And if you receive any accelerated death benefits from the policy, those aren’t taxed either.
To use the same example as earlier, say you have a cash balance of $25,000 and have paid a total of $20,000 in premiums—but this time your policy is an MEC. If you withdraw $10,000, the first $5,000 is the growth and is included in your taxable income. The next $5,000 would come from the principal.
Pros and Cons of Modified Endowment Contracts
An MEC doesn’t provide the same tax advantages as a standard life insurance contract, and most people might be better off avoiding them. However, they do provide some benefits. Here are the advantages and potential drawbacks to consider.
Pros
- MECs still provide tax-deferred growth. If you don’t plan on withdrawing from your policy, an MEC allows you to build a large cash balance on a tax-deferred basis.
- Your life insurance death benefit still isn’t taxed.
Cons
- Withdrawals come first from gains and then from your principal.
- The taxable portion of any withdrawals taken before you turn 59½ are subject to an additional 10% early withdrawal penalty.
- Loans are treated the same as withdrawals for tax purposes. Any gains come out first and are included in your taxable income. You can’t take out a tax-free loan from an MEC.
How to Avoid Converting a Life Insurance Policy into an MEC
To prevent a life insurance policy from becoming an MEC, avoid overfunding it within the first seven years. Fortunately, it’s usually easy to comply with the seven-pay test. Your life insurance provider can tell you your annual premium limit and warn you if you’re getting close.
As long as you don’t pay more than what your contract requires, your policy won’t turn into an MEC. If you do accidentally overpay, your insurer may be able to refund a portion of your premium so you stay within the seven-pay limit. Ask your provider for its rules around MECs.
Get Help Navigating MECs
If you’re considering purchasing permanent life insurance to build a cash balance, it’s important to understand how it works, the tax implications, and whether it fits into your overall financial plan.
To learn more and receive guidance tailored to your situation, contact an experienced financial professional. A Bankers Life representative can explain the difference between a standard policy and a modified endowment contract and help you understand what triggers the MEC classification.
We’re here for you!
Bankers Life is here to help customers with their financial and insurance needs so please visit us at BankersLife.com to learn more.
Insurers and their representatives are not permitted by law to offer tax or legal advice. The general and educational information here supports the sales, marketing or service of insurance policies. Based upon individuals’ particular circumstances and objectives, they should seek specific advice from their own qualified and duly-licensed independent tax or legal advisors.
Bankers Life Securities, Inc., Bankers Life Advisory Services, Inc., and their representatives do not provide legal or tax advice. Each individual should seek specific advice from their own tax or legal advisors.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Bankers Life is the marketing brand of various affiliated companies of CNO Financial Group including, Bankers Life and Casualty Company, Bankers Life Securities, Inc., and Bankers Life Advisory Services, Inc. Non-affiliated insurance products are offered through Bankers Life Securities General Agency, Inc., (dba BL General Insurance Agency, Inc., AK, AL, CA, NV, PA).
Securities and variable annuities offered through Bankers Life Securities, Inc. Member, FINRA/SIPC (dba BL Securities Inc., AL, GA, IA, IL, MI, NV, PA). Advisory products and services offered by Bankers Life Advisory Services, Inc. SEC Registered Investment Adviser (dba BL Advisory Services, Inc., AL, GA, IA, MT, NV, PA).
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk.
Investments are: Not Guaranteed—Involve Risk—May Lose Value.
