By any standard of measurement, universal life insurance revolutionized the life insurance industry. Its inherent flexibility permitted everyone involved–insurers, agents and policy owners–to create insurance programs having the potential to fulfill consumer insurance needs well into the future.
Yet, UL’s very flexibility has detracted from a key historical element of scheduled premium life insurance–forced savings. Traditional scheduled premium cash value life policies created the psychological mindset in the owner that regular premiums had to be paid to avoid policy lapse.
A fundamental feature of UL, whether fixed or variable, is that it permits premium payments to be made on a flexible basis. Indeed, UL is usually characterized as “flexible premium whole life insurance.” It can be issued as a single premium policy or designed for a series of premium payments.
The only critical element of UL’s premium payment mode is to determine whether it will be treated as a “modified endowment contract” (MEC) for purposes of the Internal Revenue Code.
If a UL is an MEC, distributions other than at the insured’s death are treated for tax purposes the same as distributions from an annuity. If it’s not an MEC, loans or other distributions can be made from policy cash values on a more tax-effective basis than is the case with pre-death MEC distributions.
To not be treated as an MEC, UL must be designed to be at least a 7-premium payment contract.
In most cases, old-style scheduled premium cash value life policies (i.e. non-ULs) will be non-MECs. Combining the non-MEC status with the psychological power of forced savings to prevent policy lapses produces very tax-effective ways for policy owners to achieve liquidity needs–particularly since these policies remain in force for significant periods of time.
Unfortunately, ULs that are treated as MECs have little flexibility to provide liquidity without the potential for significant tax disadvantages. Moreover, once issued as a MEC, a UL is pretty well locked into that status for the remainder of its duration. Worse, ULs designed as non-MECs can become MECs if actual premium payment modes change their status.