Planning out your life is one of the most seemingly impossible things to do. You can’t control everything that happens, but you can certainly prepare for what could happen. That’s why purchasing a modified endowment contract may be a smart move on your end or a nightmare.
A modified endowment contract is a policy for life insurance that differs from other life insurance policies because it does not meet some IRS guidelines.
This type of contract offers many of the benefits that other life insurance policies have. But it is often not a desirable policy to have, as there can be serious tax consequences when this type of contract has occurred.
Not quite sure whether it’s the right fit for you? We’ve compiled a guide on the pros and cons of this type of contract as part of your financial planning efforts.
Let’s get started!
What is a Modified Endowment Contract?
Modified endowment contracts, also known as MECs, are associated only with cash value types of life insurance policies. Universal life insurance and whole life insurance are two of the common types in which they could occur.
This type of contract does not pass the IRS’s 7-pay test. The test limits how much extra cash you can put into a life insurance policy during a period of seven years before the policy loses tax benefits.
In other words, you can completely pay these policies off in under seven years — something the IRS isn’t crazy about.
Because the government doesn’t want you to pay off your life insurance too quickly, it might tax policy loans or withdrawals as income.
So, why exactly does the IRS feel this way?
The government doesn’t want you to treat your life insurance policy’s cash value as an investment or savings account instead of using it cover your beneficiaries.
Despite the fact that you may lose tax advantages with a modified endowment contract, some individuals still treat it as an important component of their strategies for planning for retirement.
In addition, note that the 7-pay test applies only to those contracts issued after or on June 21 of 1988. Any contract issued earlier than this are grandfathered and thus aren’t subject to this test.
Still, a couple of policy changes may result in these contracts’ losing the grandfathered status. These include adding particular policy benefits, or a death benefit increase that requires you to provide evidence that you are insurable.
Benefits of a Modified Endowment Contract
A major reason why some people embrace modified endowment contracts is that they share the features that your traditional life policies and annuities have.
For instance, the gains associated with your contract will transfer to your beneficiary with no income taxes when you pass away. And the proceeds will avoid probate — a major plus.
Plus, this type of contract offers privacy and incontestability for your beneficiary. So, your beneficiary won’t have to worry about the potential contestations known to occur in transfers dictated by a will only.
Benefits Beyond Your Beneficiary
It’s not just your beneficiary who benefits from this type of contract.
You do, too.
For example, you’ll love experiencing the tax-deferred growth of your cash account. And the faster you fund your policy, the sooner you can begin to grow your cash account. Keep in mind, however, that there could be large tax penalties if you need the cash values before it’s time to access them.
In addition, you’ll readily embrace the creditor protection that these types of contracts may offer. This is particularly invaluable in today’s sue-happy society. After all, it’s nice to own something that is virtually untouchable.
In addition, you can essentially control your contract’s proceeds from your grave. That means you can prevent your beneficiary from misusing his or her inheritance.
Talk about having some power.
Some companies even offer policies where you can access your contract’s face amount in the event of a terminal illness or catastrophe. Also, with some contracts, you can take advantage of long-term care benefits, too.
No other kind of product can do everything a modified endowment contract can do.
What to Watch out For
Although these contracts do have pros, they also have some cons which can quickly outweigh their cons — this is primarily related to their tax implications.
As mentioned before, any pre-death distribution is taxed as income. In addition, if you’re under 59.5 years old and are not disabled, you’ll have to pay an added tax of 10% for a distribution.
Here’s a glimpse at some possibly taxable distributions:
- Cash dividends
- Policy loans, which include premium loans that are automatic
- Collateral assignments
- Dividends you apply for any reason besides reducing your contract’s premium
- Partial or full surrenders
- Account withdrawals
In light of this, you should avoid purchasing one if your intention is to access the money in it before the permissible period.
After all, even after the permissible period, you will still be taxed on gains.
Making an emergency withdrawal may be allowed, but this doesn’t necessarily mean it’s the best choice due to the negative tax implications.
Should I Buy One?
A modified endowment contract is typically promoted as an alternative to an annuity, which becomes taxable immediately upon the owner’s death.
As long as you don’t plan to complete frequent withdrawals or take out too many loans from your contract’s cash value — for example, to supplement your retirement years — you should be fine.
However, even if you end up needing to make some withdrawals, the fast tax-deferred growth you’ll enjoy may outweigh the tax costs you’ll incur in some cases.
How We Can Help
Looking for life insurance? The policy you need depends on your financial situation as well as your family and life goals.
We offer the tools necessary for you to find the right life insurance for your needs.
Contact us to learn more about modified endowment contracts. With our help, you can achieve your retirement and estate planning goals in the years ahead.