Chapter 16 Flashcards
Tax Treatment of Modified Endowment Contracts
What is a MEC contract?
During the 1980s, members of Congress were disturbed by the marketing of single-premium life insurance. In 1988, Congress changed the income tax treatment of any policy entered into on or after June 21, 1988 that fails a test titled the 7-pay test and, consequently, is classified as a modified endowment contract (MEC).
Policies entered into before June 21, 1988, were grandfathered and are not affected by this law unless they undergo a “material change.”
The 7-Pay Test
If the aggregate premiums paid at any time during the first seven years of the contract exceed the sum of the “net level premiums” that would have been paid by that time if the contract provided for paid-up benefits after the payment of seven level annual premiums. This is called the 7-pay test.
Net level premium
Net level premium is an artificially constructed amount based on reasonable mortality charges, an assumed interest rate, and (in some cases) reasonable insurance company expense charges.
Taxation of MEC contracts
Those policies entered into on or after June 21, 1988 that are classified as modified endowment contracts may be subject to income taxes and penalty taxes not applicable to other life insurance policies. Policy loans and partial withdrawals of funds from such modified endowment contracts are subject to last-in, first-out (LIFO) treatment to determine the applicable taxes.
In other words, any income earned on the contract fund is taxed as if it was withdrawn before the policyowner’s cost basis in the contract. In addition to the regular income tax, a 10 percent penalty tax is generally applicable to taxable gains withdrawn from a modified endowment contract before the policyowner reaches age 59 1⁄2. However, the 10 percent penalty does not apply to payments attributable to disability or to annuitized payments.
Exception for contracts with a $10k death benefit or less
There is a variation on the application of the net level premium amount in the 7-pay test that applies to policies of $10,000 or less in face amount. The law provides an annual allowance of $75 to be added to the 7-pay test premium. The $75 additional allowance permits some small 7-pay policies to pass the 7-pay test when they otherwise might not. The smaller the policy is, the more likely it is that the actual premium will be less than the net level premium plus $75. The full $75 can be used for any amount of coverage between $1,000 and $10,000, resulting in a maximum allowable additional expense loading of $7.50 per $1,000 of coverage.
Exchange of a MEC contract
Once a policy is classified as a MEC, it will automatically make any policy subsequently received in exchange for it also a MEC. Even if the new policy received in the exchange passes the 7-pay test, it will be classified as a MEC.
Non MEC contracts can still be subject to the LIFO rule
Owners of non-MEC contracts should be reminded that the income tax law also imposes LIFO taxation on withdrawals from non-MEC policies which are made during the first 15 policy years and are associated with a reduction in policy benefits. This situation is most likely to occur under certain universal life policies.
The 10 percent penalty will apply to the total amount of any withdrawal from a MEC.
The 10 percent penalty will apply only to that portion of a withdrawal from a MEC that is subject to the federal income tax; that is, the portion attributable to the gain in the policy on a LIFO basis. In addition, the penalty tax is generally applicable to gains withdrawn from a MEC before the policyowner reaches age 59½. Moreover, it does not apply to payments attributable to disability or annuitized payments.
A life policy death benefit increase linked directly to the consumer price index will not be treated as a material change under the MEC rules.
True
All MECs issued by the same insurer to a policyowner during any calendar year will be treated as one policy for purposes of the MEC tax rules.
True
