Many advisors 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 the product’s benefits. 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.