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Modified Endowment Contract (MEC).

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date :07-Aug-2007

Dear Subscriber:

Copyright 2007

To better understand the following discussion of the MEC rules, consider this question: What is the best investment in the world? The answer is one where money can grow tax free and be taken out tax free.

Assume you are a 45-year old male looking to reposition $100,000 of cash somewhere. You could invest in the stock market or in mutual funds. If you do that, you will have to deal with capital gains taxes, dividend taxes, money management fees and/or mutual fund expenses which will significantly hinder the ability of the money to grow annually.

What about repositioning money into a cash value life insurance policy? What if you could pay a $100,000 life insurance premium, receive a $105,000 death benefit and have $99,000 cash growing in the life policy totally tax free?

What if after ten years the amount of cash in the life policy had grown to $250,000, and you could access that cash income tax free? Would that be a good tool to grow wealth? The answer is absolutely yes, and in the “old days” that's just about what was happening in the insurance industry.

To counteract what was perceived as an abusive use of single-premium, limited-pay, and universal life policies as short-term, tax-sheltered cash accumulation or savings vehicles, Congress passed legislation modifying Code section 7702 . This Code section provides the tax law definition of a life insurance contract; and the modification created Code section 7702A, which defines a new class of insurance contracts called modified endowment contracts (MECs).

The basic difference between MECs and other life insurance contracts is the federal income tax treatment of amounts of cash received from the policy during the insured's life.

Certain “distributions under the contract” that are not generally subject to tax when received from other life insurance contracts are subject to income tax and, in some cases, a 10-percent penalty when received from policies deemed a MEC.

I am not going to go over the code section chapter and verse on MECs. Instead, I'll explain in layman's terms how the MEC rules affect the use of cash value life insurance to build wealth.

In essence, what the MEC law did was to create what in the industry is called the “7-pay test.”

What is the 7-pay test?

Based on tables and formulas that I don't profess to understand, in order to avoid having a life insurance policy become a MEC, a specific death benefit MUST be purchased from day one of purchasing a life insurance policy.

The premiums paid, what amount, and in what years drive the amount of death benefit the client is forced to purchase in order to avoid being classified as a MEC. The variable in the test is the premiums paid over a 7-year period.

The goal of Congress was to make it more painful to purchase life insurance as a tax free cash accumulator. To accomplish this goal through the 7-pay test, clients after the law passed were and are still required to purchase much more death benefit than they want.

If you think about it, insureds do not typically care that much about the death benefit when a cash value policy is used to build wealth. It is a nice benefit for the heirs to have the death benefit; but if we are honest with ourselves, wouldn't we rather have a policy where the death benefit is minimized so the cash growth can be maximized?

If you don't understand what I'm getting at with the 7-pay MEC test, the following illustration should crystallize it.

Assume you could budget $10,000 a year into a cash building policy over a 10-year period. You also have the money to fund it today with a lump sum of $100,000. Knowing that once cash is repositioned into a life insurance policy, it will grow tax -free and can be removed tax free, would you rather fund it in lump sum or over 10 years?

The answer is that you should want to fund it now so the entire $100,000 can start growing in the most tax favorable environment we can find.

The problem you'll have to deal with in this example is the MEC test.

If you funded the policy with $100,000 in year one, to avoid the policy becoming a MEC, you would be forced to purchase $2,190,157 in death benefit coverage.

If, however, you pay a premium of $10,000 a year for 10 years, the minimum death benefit you would be forced to purchase would only be $561,194.

The expenses for both the actual cost of insurance coverage as well as the other costs inside the policy are much higher with a $2,190,157 death benefit vs. a $561,194 death benefit.

While it is true you would have more money growing tax favorably in the policy if you poured the $100,000 in all at once, the additional cost in the policy due to the higher death benefit would significantly hinder the growth of that cash value.

Therefore, what advisors usually counsel their clients to do when funding the MEC minimum death benefit cash building policy is to fund it over a 5-7 year period (7 being ideal as it is right at the 7-pay window).

Roccy M. DeFrancesco, JD, CWPP™, CAPP™

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