This is a guest blog written by Justin W. Smith, founder of the insurance consulting firm, Balanced Strategies, LLC. Smith is a guest blogger for The Cavalier Strategy that focuses his research on using life insurance to guard against the biggest threats to wealth preservation. Smith is also a general agent at Cavalier Associates.
The confluence of a rising tax environment and life insurance product innovation calls for evaluation of the often avoided Modiﬁed Endowment Contract, or MEC.
As a quick refresher, the passage of The Technical and Miscellaneous Reform Act of 1988 (TAMRA) caused life insurance policies that were overfunded too quickly to be classified as Modified Endowment Contracts. Congress intended to eliminate the use of these policies as short-term savings alternatives by imposing penalties upon contracts of this type.
However, in spite of the penalties that TAMRA created, MEC’s still remain an attractive form of life insurance. In fact, among other things, they can be a great alternative to the deferred annuity.
But first, it is important to understand the penalties that Congress imposed on MEC’s.
tax consequences of a MEC
re-evaluating the MEC
|MEC rules trigger tax and a possible penalty whenever cash values are accessed through loans, withdrawals or used as collateral for any loan.
However, its important to keep in mind that the tax and possible penalties are levied on cash values only, and death benefits are paid out to beneficiaries tax-free.When cash values are accessed in a MEC policy an immediate tax is triggered on some or all of the gains. These values are taxed on a last-in, first-out basis, exposing the amount of cash pulled out of the policy, up to the amount of any gains in the policy, as ordinary income.
Additionally, for transactions accessing cash as described above prior to age 59½, there is also a 10% penalty tax. The penalty tax only applies to the portion of the distribution or loan that is included in gross income. (It should be noted that distributions taken as a result of disability before age 59½ and other unique circumstances are not subject to the penalty tax).
The lack of understanding of the tax treatment of MEC’s causes some advisors to ignore MEC designs as any sort of viable option for clients. While that’s advisable for some, for those who advise the use of deferred annuities, a closer look at MEC’s is warranted.
|Withdrawals from deferred annuities are taxed in the same last-in, first-out manner and are also subject to the 10% penalty tax if taken prior to age 59 ½. But the recommendation of a deferred annuity is often made for clients that have cash that they don’t necessarily plan on accessing.
So, why not a MEC?
With a MEC life insurance policy, when the insured dies, death benefits payable to beneficiaries transfers income-tax-free. A well-designed MEC life insurance policy can achieve attractive cash value growth, which can also push the death benefit higher during the insured’s lifetime. The death benefit in a MEC life insurance policy can be significantly greater than any value achievable in an untapped, deferred annuity.
Additionally, death benefit proceeds from a MEC life insurance policy will typically avoid probate, and in many states, life insurance assets enjoy an attractive level of asset protection which further bolsters the argument for a MEC life insurance policy.
real world implementation
Two ways that MEC’s can be phenomenal tools for clients include the reallocation of cash-equivalents into a MEC life insurance policy and a living-benefits focused annuity alternative.
reallocation of cash equivalents
The first scenario I describe allows clients to leverage the potential for a higher return on cash than money-markets, CD’s or savings accounts in the form of tax-deferred growth of cash value with the incredible feature of the tax-free death benefit that leverages the underlying cash value in a way that no other cash-equivalent instrument can.
Structured the right way, a survivorship policy can be designed to remove or dramatically reduce surrender charges, providing in some instances 100% of premiums paid as cash surrender value in the first policy year. Some of these policies have a minimum guaranteed crediting rate of 3%, which is quite attractive in this interest rate environment.
Despite the allocation of some account values to cost of insurance charges and policy fees, the net internal rate of return on cash surrender value can average greater than 1.50% or more during the first 10 or so policy years.
If the policy is owned by the insured and/or their spouse, the ability to disclaim the policy at the first insured’s passing and pay a transfer tax at that time could allow the policy to be moved outside of the estate so that when death benefits become payable at the second insured’s death, they are not subject to estate tax and transfer to heirs tax free. This can achieve fantastic leverage that other assets cannot.
living-benefits focused annuity alternative
The second scenario I refer to is where product innovation allows us tools to create a unique asset for clients. The use of a MEC, Indexed Universal Life (IUL) insurance product with a long term care rider can be a smart recommendation for some clients.
The ability to use a single premium payment, for example, into a carefully selected IUL product that, while still having cost of insurance and policy charges, limits exposure to index downside and provides upside potential higher than an indexed annuity can make it very attractive. When you add the long term care rider it becomes one our most capable tools (note that the roughly $1.2 billion aggregate premium per year MoneyGuard product from Lincoln National is a MEC UL policy chassis!).
So, with this design, the client puts money into an annuity-like vehicle that has the potential to participate in some index growth, enjoys the peace of mind knowing that they can use the policy to access cash values, if needed (taxed as described above) as well as having long term care benefits available if triggered along with the tax-free death benefit.
It is an extraordinary policy that kind of resembles the Swiss army knife, providing tools for a wide variety of concerns. (Bear in mind that in spite of the taxation rules of a MEC policy, the LTC benefits payable under the LTC rider are received tax-free).
utilizing the MEC
These are just a couple of the many designs that MEC life insurance policies can achieve. Carefully structured MEC designs that properly consider all of the tax consequences associated with MECs can provide extraordinary value and benefits that other products cannot.
Whether a cash-equivalent sale or an annuity alternative that has been designed smartly to feature living benefits, potential upside and the attractive tax free-death benefit, I believe that the inclusion of these products by life insurance professionals in their daily planning can uncover opportunities that are often overlooked.