29 May 2014 0 Comments

Is a MEC bad? Can it be avoided?

shutterstock_126537509The term “MEC” is an acronym for Modified Endowment Contract.  A MEC is created when the premiums paid in the first 7 years of a life insurance policy exceed certain limits.  Unless you’re an actuary there is no need to know the formulae that defines those limits.  If you are contemplating the purchase of a policy and have planned on paying premiums that would create a MEC, the policy illustration will indicate this fact.

A MEC does not carry all of the tax advantages of a normal life insurance policy, but only with regards to cash withdrawn or borrowed from the policy during the life of the insured.  The death benefit of a MEC is received tax free, just like any other life insurance policy. However, distribution of cash value during the life of the insured is taxed as though the policy was a Deferred Annuity as opposed to life insurance.   This means that taxation will be on a Last-in-First-Out tax basis, instead of First-in-First-Out applicable to life insurance living distributions.  It also means that policy loans will be treated as a withdrawal and there is a 10% tax penalty for distributions prior to the age of 59 ½.

A MEC became a part of the tax code several years ago as the result of the use of single premium Life Insurance that was designed with very little death benefit and was being used just like an annuity, but without the less favorable tax treatment.

If you never withdraw cash during the life of the insured and/or the cash value never exceeds the premiums paid, there is no adverse effect of having a MEC.  However, if your planned premium pattern creates a MEC and you would like to avoid any possible adverse tax treatment, here are some pointers:

  • If premiums for a new policy are coming from the cash values of another policy being replaced, be sure that the cash is transferred in accordance with IRC Section 1035 directly from the current insurance company (policy) to the new policy.  This will likely avoid the early excessive premium problem.
  • If premiums for the new policy are coming from any other source, then instead of paying them all in the first year. Place them in an interest baring account and withdraw them spread over 5-7 years.  At least one company has a Premium Deposit Fund Rider available for this purpose that pays a competitive interest rate and sets up the premium payment to be withdrawn annually.  This rider should be no load and non-commissionable.  An annuity is probably not a good option due to the charges incurred for such a short payout period.

There are often good reasons to pay large premiums into a policy in the early years.  Just be aware of what a MEC is and, if concerned, how to avoid it.

Clarification of more life insurance terminology will be next.

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