Ever since the Internal Revenue Code was enacted in 1913, people have been trying to use its provisions for their benefit. Whenever Congress feels that a particular instrument’s tax preference is being used in a manner that was not intended, it will either eliminate or modify the tax preference. And that is exactly what it did regarding the tax deferral of the cash value of life insurance.
Life insurance has two primary tax preferences: 1) the death benefit is generally tax free to the beneficiary(ies), and 2) the inside build-up (cash value) is not taxed on an annual basis. A secondary benefit it that the cash value is taxed on a first-in first-out (FIFO) basis, meaning all premiums can be withdrawn before incurring any tax.
The high interest rates of the 1980s meant high yields not only on bonds and CDs, but also on life insurance policies. But the interest on bonds (other than municipals) and CDs was taxable, whereas the cash value of life insurance was not. That led to the creation of single premium life insurance, where the death benefit was immaterial; the only thing that mattered was how quickly the cash value grew. So Congress stepped in.
In 1988, the Technical and Miscellaneous Revenue Act (TAMRA) was enacted. One of its provisions was the creation of a class of life insurance policies known as “modified endowment contracts” (MECs). MECs primary purpose was to discourage the use of life insurance a tax-sheltered investment vehicle.
The details of what makes a policy a MEC are beyond the scope of this essay, but generally, aggressively overfunding a policy will push it into MEC status. It is important to understand the pitfalls of having a policy classified as a MEC.
First, withdrawals are classified as last-in first-out (LIFO) instead of FIFO. That means all withdrawals over the basis is the contract will be taxed first, before basis is withdrawn as a return of principal. Second, all withdrawals (including loans) made before age 59½ will be subject to a 10% penalty tax. These two provisions remove the attractiveness of overfunding a life insurance policy to take advantage of its tax deferral feature.
It is equally important to understand that MEC status does not affect the tax free nature of the death benefit. The same rules that apply to determining the taxability of a non-MEC death benefit apply to MECs.
Additionally, a policy that is not a MEC at issue can become one through a variety of actions. However, almost all “street” policies are designed to avoid MEC status.
So if you’re planning to use your life insurance policy’s cash values to fund college or perhaps pay off your mortgage early, it would be wise to make sure that policy isn’t (and won’t become) a MEC.