By Robert P. Murphy
Whenever a newcomer is introduced to the wonders of dividend-paying whole life insurance, he soon encounters the dangers of overfunding and hence “MEC”-ing a policy. In this article I’ll give a quick primer on what this status means, where it came from, and the ramifications it has for policyholders.
The acronym “MEC” is short for “modified endowment contract.” To say that you “MEC”ed a policy means that you stuffed it with too much money and hence the IRS will now cease to classify it as a standard life insurance contract (the purpose of which is to provide a death benefit), but instead will classify it as an endowment contract (a modified one, to be specific).
According to Wikipedia, an endowment policy “is a life insurance contract designed to pay a lump sum after a specified term (on its ‘maturity’) or on death. Typical maturities are ten, fifteen, or twenty years up to a certain age limit.” So the distinguishing feature of an endowment policy—in contrast to standard life insurance—is that there is a good chance it will mature and pay out before the insured dies. It’s still life insurance—both in fact and even according to the government’s own definition—but an endowment policy is designed more as a short-term savings vehicle, rather than as a hedge against death.
In this context, it’s more understandable now why the IRS classifies policies stuffed with cash early on as “modified endowment contracts.” The idea is that the policyholder is using the special IRS treatment of life insurance as a way to let his wealth accumulate in a tax shelter. (As Jerry Seinfeld might say, “…not that there’s anything wrong with that.”) Thus, the IRS is declaring, “Because this is suspiciously designed to take advantage of the favorable tax-deferred build-up of assets, rather than as a way of funding widows and orphans in the event of an untimely death, we are going to put in some extra rules to make sure things don’t get carried away.”
To reiterate, I am not here to endorse the IRS’ attitude on this issue. I am merely trying to explain where this odd term “MEC” comes from, since it is of such crucial importance in the actual implementation of cash management via whole life policies.
The Origin Of The MEC Rules
What we now know of as the MEC test came into effect in the Technical Corrections Act of 1988 (H.R. 4333, S. 2238). Officially the measure was in response to the widespread use of single-premium life policies by wealthy individuals.
It it amusing to watch the IRS change its policies time and again. They put punitive tax rates in effect, and then act like they’re being generous by granting pockets of exemptions from the very taxation that they instituted. When people quite rationally respond to the system of incentives, the IRS is shocked, shocked at the outcome and tinkers with the rules. Rinse and repeat, ad infinitum. As Nelson Nash asks, “Don’t you start to get a little suspicious?”
Later in the article I’ll have more to say about the relationship between the tax code and whole life insurance, but for now let us simply observe: How can it be that Dave Ramsey and the other gurus so confidently tell us how awful life insurance is, when the government needed to put in special rules to stop rich people from stuffing their money into it? Do Ramsey et al. really mean, “Oh, starting in 1989 whole life insurance was awful, but before then it was great”? Do they even know about the MEC change?
The 7-Pay Test
An online article reprinted from Forefield, Inc. provides a good summary of the MEC criteria and penalties. With the understanding that I am an economist—not a qualified tax professional—let me give the basics for the novice readers:
The IRS can classify a whole life policy as a modified endowment contract (MEC) if money is put into the policy too rapidly during its first seven years. More specifically, the IRS first calculates the annual level premiums one would pay on a policy with the same death benefit to have it fully paid up after seven years. Then the IRS looks at the cumulative payments into the actual policy during the first seven years. If, at any time, the cumulative payments on the actual policy are higher than the cumulative payments on the 7-year-pay whole life contract with the same death benefit, then the policy is a MEC.
There are some subtleties with this definition. For one thing, it’s permissible in any particular year to put more into the policy, than would happen in any particular year with a level premium in the 7-year-pay policy. This can happen if the person doesn’t put too much into the policy in the first (say) three years, and then dumps in a large amount of cash in the fourth year. So long as the cumulative amount in years 1 through 4 isn’t higher than the cumulative premium payments on a hypothetical 7-year-pay policy with the same death benefit, the policy isn’t a MEC.
On the other hand, this flexibility doesn’t run the other way. If an owner dumps too much money into the policy early on (in the second year, say), such that the cumulative contributions at that point exceed the cumulative premiums on the hypothetical 7-pay policy, then the policy is a MEC, period. It doesn’t matter if the person contributes much lower amounts in years 3 through 7, so that eventually the cumulative contributions in reality are lower than the cumulative contributions for the hypothetical 7-pay policy. Once a MEC, always a MEC. You can’t “get square” by holding back on future contributions.
Finally, we should note that whenever there is a “material change” to a policy—which includes a change in the face amount—it must be subjected to a new 7-pay test going forward from the date of the material change.
Why Term Riders Help Pass The MEC Test
Now that we understand the origin and the specifics of the MEC test, we can understand why insurance agents will often recommend including a level term rider for, say, the first ten years of a new whole life policy. (In other words, the base whole life policy might have a 10-year term life insurance policy appended onto it.)
By coupling a new whole life policy with a level term rider, the overall death benefit of the policy can be raised significantly in the early years of the policy, and for lower premium outlays than would be necessary to have the same death benefit in a standard whole life policy. Yet because (as we’ve seen) the MEC test is based on the level premiums for a 7-pay policy with the same death benefit, the boosting of the death benefit (by adding the term rider) thereby boosts the annual premiums in the hypothetical 7-pay policy. Therefore, the addition of the level term rider “opens up” the policy, and allows the owner to contribute higher amounts in the first seven years without turning it into a MEC.
Although the level term riders can be quite useful in designing policies that accommodate an owner’s cashflow goals while steering clear of the MEC limits, we should emphasize that term level riders were not invented merely as a way to circumvent the new tax laws. On the contrary, whole life policies had term riders before 1988, and the reason was simple: Because of their relatively higher premiums, whole life policies in certain circumstances didn’t provide enough death benefit early on, and so households might supplement a standard whole life policy with a term rider in the first (say) ten years. By the time the term policy fell away, the underlying whole life policy’s death benefit could have grown because of Paid Up Additions made by the policyholder during the intervening years.
Penalties From A MEC
Although agents trained to implement the Infinite Banking Concept will want to avoid MECs like the plague, we should be clear that MECs are actually still life insurance per the government’s classification, and hence still enjoy the standard tax-free treatment when death benefits are paid to a policy’s beneficiary.
However, the supreme drawback to a MEC—which is of crucial importance for anyone using whole life policies for their cashflow or “banking” qualities—is that the policyholder forfeits the special tax treatment normally afforded to the use of the cash value while still alive, including policy loans and withdrawals. For example, if a person has a basis (meaning lifetime premium payments) of $50,000 in a policy that now has a cash value of $80,000, and the person takes out a $70,000 policy loan, then $20,000 of the loan will be subject to standard income taxation as a gain. In contrast, with a non-MEC policy, all policy loans—even beyond the “basis” in the policy—can be taken with no income tax consequences, because strictly speaking a loan isn’t income.
Remember, the IRS instituted the MEC test as a way of discouraging individuals from using life insurance policies (such as single-pay policies) as tax-privileged savings vehicles. That is why a MEC has penalties applied to something as innocuous as taking a loan from a financial institution with another asset serving as the collateral. From an accounting standpoint, a loan really isn’t income, and so has no business being taxed as such. Yet accounting principles go out the window when the IRS is trying to contain the ramifications of its own policies.
There are other constraints imposed on a MEC. For example, beyond regular income tax, there are additional penalties placed on withdrawals before the age of 59½. Thus the standard paternalistic treatment of IRAs, 401(k)s, etc. kicks in with MECs. Since the whole point for many people of dividend-paying whole life insurance is precisely to avoid this busybody regulation of how a person can use his own wealth, it is particularly important to avoid MEC status.
“Won’t They Just Change The Tax Laws Again?”
In reading this discussion, some newcomers might be discouraged and decide that dividend-paying whole life policies, though they seem to be quite extraordinary in several respects, are actually too good to be true, and will probably be “shut down” by the government with yet another change in the IRS code.
This view is simplistic for two reasons. First, it suffers from the Yogi Berra flaw of not going to a restaurant because it’s too crowded. In other words, it can’t simultaneously be the case that “nobody should buy whole life policies” and “the government will soon crack down on this practice because it’s too popular.”
The view is also wrong because it overlooks a crucial fact about the 1988 creation of the MEC test: The tax law changes grandfathered in policies that were already in force. In other words, people who had bought large cash-value policies before mid-1988 didn’t lose the tax advantages prevailing when they first acquired the policies. The only thing that would make them vulnerable to a MEC test would be a “material change” in the policies, after mid-1988.
In this light, then, it is particularly silly for someone to say, “I love everything Nelson Nash teaches, but I’m just afraid the government will break up the party.” If that’s the objection, then take heart: Although it’s certainly possible the government will tighten up the rules going forward, it would be less likely to retroactively apply the new rules to policies already in force.
It is undeniable that one of the major attractions of dividend-paying whole life insurance policies is their special tax status. Even though one must be careful to use the conservative term “tax-deferred,” in practice the growth of a policy’s internal cash value can be used (through policy loans) and ultimately passed on to the beneficiary with no taxation. In light of these facts, I am constantly amazed at the confidence with which financial gurus tell their fans that life insurance is “a terrible place to put your money.”
Even so, Nelson Nash has always made it clear that dividend-paying whole life insurance policies are not a creature of the tax code. Permanent life insurance policies existed well before 1913 (when the IRS was created). If the tax laws are altered again, life will go on for the insurance sector, and (depending on the specifics) it will still probably make a great deal of sense for middle- and upper-income households to own whole life policies. After all, despite the 1988 changes in the tax treatment, no whole life policyholders were complaining when the market crashed in 2008.