Life Insurance Premium Limits (MECs)

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1 Life Insurance Premium Limits (MECs) Life insurance contracts enjoy a special tax benefit because the growth in cash values during the term of the contract is not currently taxed. In addition, when there is sufficient cash value accumulated, the policyowner may take low-interest, nontaxable loans. However, loans do potentially lower the death benefit and accrue interest. These tax benefits led some policyowners to begin using life insurance contracts not primarily for death protection, but instead as a tax-favored investment. That is, the premium paid could be many times the amount required to pay for the insurance, with the excess going into the cash value to accumulate tax-deferred. The policyowner could then borrow from the cash value without tax consequences. To discourage the use of life insurance policies for tax avoidance, Congress imposed limitations on how much money may be paid into a life insurance policy overall, and within a certain period of time. Section 7702 of the Internal Revenue Code established this cap. If the 7702 limits are exceeded, the policy becomes a Modified Endowment Contract, or MEC. A MEC, even a singlepremium life insurance policy, can still qualify for the income taxfree death benefit and tax-deferred inside buildup generally available for life insurance policies. However, distributions from a MEC are not tax-favored but are subject to certain special rules: Gains withdrawn, even by loan, are subject to income taxation if there is gain in the policy. Gains are deemed taken from the policy first, before the already-taxed money (the premiums) may be withdrawn. This rule requires that, until the gains are completely exhausted by withdrawals or loans, all funds received must be included in gross income. Only after all taxable earnings are withdrawn is the nontaxable principal withdrawn. page 1 of 5

2 A 10 percent additional penalty tax is imposed on amounts received from a MEC that are includable in the policyowner s gross income unless such amounts are received: after the policyowner has become disabled; after the policyowner has reached age 59 1/2; or in the form of a series of substantially equal periodic payments for the life or life expectancy of the policyowner, or for the joint lives or life expectancies or the policyowner and his/her beneficiary. The limits imposed on MECs are not stated in general as a certain dollar amount. Instead, the limits have to do with the relationship between: The cumulative premiums actually paid during the first seven years and The cumulative net level premiums permitted during the same seven years. This is called the 7-pay test. To meet the requirements, policy premiums must be small enough in amount and sufficiently spread out in time that they are able to pass the test using accepted actuarial guidelines. Insurance companies determine the limits of the permitted net level premium amounts policy-by-policy when each policy is first issued, based on the MEC rules. If there is a material change in the policy, such as (but not limited to) an increase in the benefits provided or additional benefits, the policy will be treated as a new contract as of the date of the material change. The 7-pay test must again be satisfied, starting on the date of the material change. If there is a reduction in benefits during the first seven years of the contract, the MEC definition is applied as if the contract had originally been issued at the reduced benefit level. However, any reduction in benefits that is attributable to the non-payment of premiums due under the contract is not considered a reduction in benefits if the benefits are reinstated within 90 days. page 2 of 5

3 This illustration shows one policy that meets the 7-pay test and another that does not. Remember, cumulative premiums must not exceed the total of the permitted cumulative net level premiums paid for the same period. For this example, assume the annual net level premium for each policy is $2,000, but over the 7-year period, varying amounts have been paid as shown below. Policy #1 Policy #1 Policy #2 Policy #2 7-Pay Annual Cumulative Annual Cumulative MEC Limit Premiums Premiums Premiums Premiums Premiums Paid Paid Paid Paid Permitted Year 1 $2,000 $2,000 $2,000 $2,000 $2,000 Year 2 $2,000 $4,000 $1,000 $3,000 $4,000 Year 3 $1,000 $5,000 $2,000 $5,000 $6,000 Year 4 $3,000 $8,000 $2,000 $7,000 $8,000 Year 5 $3,000 $11,000 $1,500 $8,500 $10,000 Year 6 $2,500 $13,500 $2,000 $10,500 $12,000 Year 7 $1,000 $14,500 $3,000 $13,500 $14,000 By the 5th year, the first policyowner has paid excessive premiums, reaching a cumulative total ($11,000) that is greater than the permitted 7-pay limit ($10,000). Unless the excess premium in year 5 is timely refunded, this policy becomes a Modified Endowment Contract and is no longer eligible for some of the tax benefits afforded a life insurance policy. The second policy stays within the limits, so there are no negative consequences. page 3 of 5

4 Life Insurance Premium Limits (MECs) What Is Meant by Life Insurance Premium Limits and MECs? Life insurance policies enjoy certain tax benefits that are not available in other savings vehicles. One of these is a tax-free buildup of cash value that can be accessed through nontaxable loans. If the owner of a life insurance policy pays excessive premiums in order to increase the cash value, the policy will become a Modified Endowment Contract (MEC). A MEC can still qualify for the income tax-free death benefit and tax-deferred inside buildup generally available for life insurance policies. But the earnings in the MEC are subject to taxation when withdrawn. To discourage the use of life insurance policies as tax-deferred investment vehicles, Congress has placed limits on the premium amounts that may be paid over a seven-year period. When those limits are exceeded, the policy becomes a Modified Endowment Contract. What Are the Consequences When a Policy Becomes a MEC? All earnings taken from the cash value, even by loan, are subject to current income taxation. And, if cash value is withdrawn, the earnings are deemed taken first, before any of the principal, which has already been taxed. Under this approach, until all earnings are withdrawn and taxed, no withdrawal is attributed to the nontaxable principal. Additionally, any amount withdrawn is subject to a 10% penalty tax unless the policyowner (1) becomes disabled, (2) has reached age 59 1/2, or (3) receives the distribution as part of a series of substantially equal periodic payments made for: The policyowner s life or life expectancy or The joint lives or joint life expectancies of the policyowner and his or her beneficiary. How Do These Limits Work? When an insurance policy is first issued, the insurance company determines the maximum net level premium amounts permitted by the MEC rules for that particular policy using accepted actuarial guidelines. The annual amounts of premiums paid must stay within those limits during the first seven years of the policy, and if they do, the policy has met what is called the 7-pay test. The 7-pay test compares cumulative premiums actually paid during the first seven years and the cumulative net level premiums permitted for that same period. The 7-pay test applies at issue (hence the first 7 years) but also applies for 7 years following a material change. If at any point during the seven years the cumulative premiums paid exceed the permitted amount, the policy becomes a Modified Endowment Contract subject to adverse tax consequences (provided the excess is not timely refunded). page 4 of 5

5 We want to thank you for your interest in our professional services, and for this opportunity to present a financial concept that may be pertinent in your personal circumstances. Please contact us if we can answer any questions you have, or if we can provide any additional information on this or other financial topics. page 5 of 5