Withdrawing From a MEC Owned by a Life Insurance Trust
The tax code limits the use of tax benefits of life insurance to accumulate cash with a small insurance benefit. Funding a cash-rich life insurance policy can result in the policy becoming a modified endowment contract (“MEC”) under the tax code. MECs are subject to less favorable tax rules than typical policies.
So long as the policy is held until the insured’s death, MEC status does not pose a problem; MEC death benefits are still tax-free. However, withdrawing from a MEC policy during the insured’s life typically results in income taxable to the insured to the extent the policy value exceeds the premiums paid. This withdrawal can cause the insured to incur “phantom income” – receiving an income tax bill but no income if the policy is owned in a typical life insurance trust.
Solution: Use a non-MEC policy or other assets to obtain the cash. The MEC status only applies to the gain within the policy, therefore if the gain is minimal, the tax bill may be collateral damage to completing the overall transaction.
Not Tracking MEC Status
Many policy owners have exchanged their older policies for newer, less expensive policies. However, changing into a new policy does not wash away the MEC status. Toes can be stubbed on the MEC tax rules if MEC status is not reflected on the new policy as it is still a MEC following the exchange.
Solution: Good record keeping by policy-owners can avoid MEC status. Likewise, when exchanging policies, make sure the MEC status is also noted on the new policy.
Surrendering a Policy Instead of Exchanging a Policy (or Vice Versa for MECs)
There are two ways to use the current value of a policy to buy a new policy: exchange the policies or surrender the old policy and buy the new policy. These two approaches have drastically different tax treatment. An exchange credits the cash value of the policy to the new policy with no tax ramifications to the owner. A surrender will cause the owner to be taxed on any gain in the policy.
In an exchange if the old policy is a MEC, the new policy will inherit MEC status. Therefore, if the gain is minimal it may make sense to surrender the policy and pay a small amount of tax rather than exchange the policy. This maneuver prevents the new policy from being tainted by MEC status causing future gains to be unnecessarily taxed if withdrawn.
Solution: Analyze any major trust changes with your insurance agent or financial advisor.
Not Correcting MEC Status
If a policy owner triggers MEC status, the carrier typically notifies the owner that MEC status has been triggered. The good news is that this can be fixed! The tax code specifies that if the premium payment causing the policy to become a MEC is refunded to the policy owner with 60 days of the end of the policy year in which the payment was made that MEC status can be reversed. It’s a rare opportunity to take a mulligan. If you receive such a notice, call your advisor as soon as possible to discuss refunding the excess payment to cure MEC status.
