Many financial producers now consider modified endowment contracts (MECs) a tool of the past in structuring clients’ product portfolios — but in many cases, dismissing the MEC too quickly can cause your clients to miss out on a valuable product. While it’s important that your clients understand the potentially adverse tax consequences of MEC classification, they should also understand the key role that MECs can play both in estate and postretirement healthcare planning. For clients with sufficient means, the opportunity to rapidly fund a life insurance contract so as to become subject to the rules governing MECs may actually provide a powerful strategy in the well-rounded planner’s arsenal.
The MEC and the Modern Portfolio
A MEC is essentially a type of cash value life insurance policy that is subject to less favorable tax rules (discussed below) because it has been funded with premiums during the first seven years of the policy’s existence that exceed certain maximum amounts (depending on the policy’s benefit level and cost).
Despite this, the MEC’s worth today can remain substantial. In many cases, clients purchase life insurance products that they do not intend to use as income planning vehicles. These clients can benefit from overfunding a life insurance policy in the policy’s early years because tax-deferred growth is maximized through this strategy — so that the MEC can function as an enhanced estate planning tool for maximizing the tax-free death benefits that will be received by the client’s beneficiaries.
MECs may also provide a minimum guaranteed level of growth throughout the policy’s life, which can eliminate the downside risk that equity investments and traditional retirement-type accounts might create.
As is the case with traditional cash value life insurance and annuity contracts, MECs can be structured as “hybrid” type policies that offer long-term care benefits to help fund a client’s postretirement medical expenses. These long-term care benefits can be taken tax-free from the MEC in the same manner as with other financial products. Because hybrid MEC policies generally allow the client to maximize tax-deferred growth through large up-front premium payments, the potential for accumulation to provide these benefits is heightened with the MEC, as compared to an annuity or traditional life insurance policy.
The Tax Plight of the MEC
Certain tax treatment traditionally afforded to life insurance is denied to MECs because of Congress’ desire to discourage the use of these policies for tax-free loans, rather than for the life insurance function they were originally meant to serve.
In the past, high net worth clients would heavily fund a cash value life insurance policy early in the contract’s inception in order to quickly build the policy cash value so that the owner could tap the policy for tax-free loans, thereby escaping high ordinary income tax rates. In response, Congress provided that if a contract fails a “seven pay test,” any cash value withdrawn from the policy is taxed on an income-first basis, rather than as a tax-free recovery of the client’s cost basis. This means that any policy loans will be taxable to the extent of any gain on the policy.
Further, an additional 10 percent penalty may be added to the basic ordinary income tax rate imposed on any withdrawals from a MEC if the client has not yet reached age 59½ (subject to certain exceptions). These tax rules apply only to lifetime withdrawals — any death proceeds are received tax-free, just as any other life insurance policy.
The seven-pay test basically transforms any cash value life insurance policy into a MEC, if a client contributes premiums in excess of the actual cost of the policy for the first seven years. For example, if the policy costs $10,000 per year for seven years and the client contributes $10,000 in year one and makes an additional contribution in year two, the policy will become a MEC. Once the policy has gained MEC status, it is irrevocable.
While MECs might not be the right solution for every client, it is not time to take them off the table just yet — higher net worth clients can continue to benefit from their use today in spite of the tax restrictions that apply to cash value loans.
For previous coverage of postretirement healthcare funding strategies in Advisor’s Journal, seeOverlooked Postretirement Healthcare Strategy.
For in-depth analysis of the rules governing MECs, see Advisor’s Main Library: A—Death Proceeds of Life Insurance.
Your questions and comments are always welcome. Please contact the Panel of Experts.