The Modified Endowment Contract aka The MEC

Home » June 2015 » The Modified Endowment Contract aka The MEC

L. Carlos Lara

August 29, 2014

For those of us who have read Nelson Nash’s book, Becoming Your Own Banker, or even for those of us who are just now entertaining the idea of doing so, the resultant understanding after reading it is that the platform used to set up the process for becoming your own banker requires a specially designed insurance contract. To be even more specific, it requires a dividend-paying Whole Life insurance policy with a special codicil known as a Paid-up Additions Rider. Of course, if you are not at all familiar with insurance vernacular, it’s very possible that these terms may easily confuse you and soon have you scratching your head. Please understand that this is not at all intentional on the part of Nash, actually it’s his best attempt of doing just the opposite since he is aware that he is writing to the general public, not financial professionals. He keeps his explanations light and uncomplicated for the public’s benefit knowing full well that the public is generally unsophisticated in these matters and that the experienced insurance professional will be able to explain the technicalities of all these terms at the proper time.

This same undemanding explanation holds true when he introduces the Modified Endowment Contract (MEC) on page 38 of his book. By simply drawing a spectrum of various life insurance plans with a term policy at one end and a single-premium whole life policy at the other end, he then instructs the reader not to cross the line into the single-premium policy territory. In reality, however, following these instructions can only be accomplished using a life insurance illustration provided by an insurance professional. But here within the context of his book, Nash is providing the reader with facts that are important to his understanding when it comes time to prepare the illustrations. The caution he gives to not cross into the territory of the single-premium policy is because the IRS, by a ruling made in the 1980s, will change the treatment of the policy from a standard insurance contract to an endowment contract.

Generally speaking, an endowment, for those that may not be acquainted with its detail, is funds, or property, received from an external donor. Donors usually give these bequests to non-profit organizations for an institution’s on going support, with restrictions that the principal of the gift is to be retained in perpetuity. It can be spent only with certain stipulations. These non-profit recipients may include academic institutions, cultural institutions, such as museums or libraries, and religious organizations: think of “Harvard’s endowment.” Such institutions we all know are tax-exempt, but here in the explanation Nash is giving in his book the recipient is not always a non-profit and the tax-free withdrawal aspects contained in an insurance contract present certain technical issues that were noted by Congress and quickly addressed. Nash, who is familiar with the tax law, points out that as an endowment contract “any withdrawal or loan from the plan would be treated as a distribution and would be taxed as from any other accumulation account, i.e., part is capital and part is earnings. The earnings portion is taxed as ordinary income in the year the withdrawal or loan is made. It is not a matter of earth-shaking consequences, but it can be avoided with a little bit of understanding of just what is going on.”1

The purpose of this LMR article is to expand our knowledge on this important subject, discuss how this law came about, and hopefully shed some light on what is going on. Once we see what is really happening we realize the power of an IBC policy and what it is capable of doing in the economic climate we find ourselves in.

The 1970s: Inflation and Its Impact on Savings

To better understand how the MEC rule came to be enacted we need to walk through history over the last 40 years and keep our mind’s eye on the bigger picture. You should first realize that prior to 1960 most American households owned a dividend-paying Whole Life insurance policy as one of the best methods to save money, besides the conventional savings account at a commercial bank, or in bonds. A Whole Life policy was well known and understood by the average American. It had taken them safely through the Great Depression at a time when Wall Street and so many of the country’s banks had failed. To that generation a Whole Life policy was as safe as cash under the mattress. But something dramatic happened in the 1970s that changed all of that and brought economic ramifications both domestically and globally. In 1971 President Richard Nixon2 closed the gold window internationally and shocked the world. This one act unlinked the dollar from the precious metals, finally ending the last remnants of the classical gold standard. Shortly thereafter, with no restraints to the printing presses, a torrent of inflation was unleashed upon the world.

The results began to be felt in our pocket books before we knew it, but our full understanding of how it all came about and the more severe ramifications yet to come were still in the future. Few could have foreseen the emboldened powers of the Federal Reserve we see today or government’s increasing role over the entire economy. Or even what inflation really is! Most Americans only witnessed the rising prices on everything including stocks and we took note of that. Now with the stock market promising higher rates of returns, Americans moved away from traditional savings plans that now seemed slow and boring and plunged into the speculation markets. With the emergence of the mutual fund, the transition was made easier. Real estate, which had a tax-sheltering component at the time, surged to record highs. By the end of the 1970s and early eighties the correction came with full force and interest rates skyrocketed to 23% on commercial bank loans! Suddenly there was panic on the streets.

The Tax Reform Act of 1986

The Tax Reform Act of 1986,3 which came during Reagan’s term in office, also had enormous ramifications for Americans coming on the heels of an inflationary decade. This tax law was specifically targeted to increase corporate taxes, increase capital gains taxes, and generally broaden the Tax Code; its enactment successfully brought billions into the coffers of the U.S. Treasury, but in so doing virtually eliminated all known tax shelters for the wealthy. Tax havens at the time were tied to real estate in the form of limited liability corporations. The passing of the Tax Reform Act of 1986 set off a nationwide collapse of the commercial and residential real estate markets and a wave of business and personal bankruptcies followed. In fact, it was the worst real estate collapse since the Great Depression. Hundreds of shopping centers literally stopped construction in midstream and were virtually abandoned. Large office buildings and office complexes in major cities lay dormant and empty as white elephants. It remained this way for several years and people wondered if this was the end to all future real estate investments. These dramatic economic events eventually tipped the scales of the prevailing panicked mood of Americans and set off the great stock market crash of October 19, 1987 famously known as “Black Monday,” when $500 billion was lost in one day. There was a sense that things were getting out of control.

Meanwhile, the wealthy having been thrown out of their tax sanctuaries began pressing their tax attorneys and advisors for a new tax refuge and the answer soon came back with urgency earmarked with these general instructions—“write one check — a big check— and drop it into a Single-Premium Whole Life Insurance Policy!” These directives seem almost strange when all we hear today is that Whole Life is the worst place to put your money. Nevertheless, these were the guidelines coming from the top tax advisors in the nation who were on the payroll of America’s richest families. The advice was quickly heeded. But why were the wealthy advised to do this? The answer is simply this—the tax benefits and the control over one’s money offered to policy owners of a Whole Life contract. When you look around and discover that nothing else offers such benefits, why not “overfund” one of these policies with the entirety of your wealth? As it came to pass the wealthy took immediate action and the money poured into these policies soon got the attention of the regulators who noticed that they were being used, not merely as insurance policies, but also as a way to shield wealth from taxes. Consequently, in June of 1988 Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) to specifically curb these actions, and the single-premium policy was declared a Modified Endowment Contract (MEC).4

Although all of the policies issued prior to this date were grandfathered in (subject to material changes in the policy), and are not subject to the new tax rules, single-premium Whole Life policies written after this date are now all MEC policies. This is a designation that remains to this day.

The following tax rules apply to Modified Endowment Contracts and are listed here as only general guidelines:

  1. Distributions will switch from a First In First Out (FIFO) basis to a Last In Last Out (LIFO) basis. This means that withdrawals will require the policy owner to withdraw taxable gain before withdrawing un-taxable basis.
  2. Policy loans will be realized as ordinary income to the policy owner and could be subject to income taxes in the year the loan is made.
  3. Distributions (either withdrawals or loans) that go beyond the policy basis will be subject to a 10% penalty tax for policy owners under the age of 59.5 In effect; a MEC insurance policy is now taxed much like an annuity or any other government qualified plan.

The Corridor Rule: Although a single big check can no longer be made to “overfund” a policy and completely pay it up without it being classified a MEC, the IRS’s so-called 7-pay test that came along in conjunction with TAMRA does allow you (provided you follow the rules) to make seven individual checks, one each year, and virtually accomplish the same thing without it being a MEC. It just takes longer.

In a general sense, the corridor rule states that in order for any life insurance policy to avoid being classified as a MEC, there must be a “corridor” of difference in dollar value between the death benefit and the cash value of the policy. What is being eliminated or discouraged are premium payments that would make the cash value of the policy higher at any point in the first seven years, compared to a hypothetical policy of comparable death benefit that would be fully paid-up after seven equal premium payments.

Material Changes: Important to all of this is the fact that once an insurance contract becomes a MEC, the status is irrevocable. Of even more noteworthy importance is that the 7-pay test described above must be satisfied not just at the inception of a new policy, but also anytime during the life of the policy if it undergoes a “material change.” The legislative history of a MEC defines material changes as those having to do with any increases in future benefits caused by a policy exchange, such as a 1035 exchange and a conversion from term to permanent insurance as specific examples. Increases in the death benefit or the addition of riders can have a material change on a policy. If a policy undergoes a material change, a new 7-pay premium is calculated using the age of the insured and the policy’s death benefit at the time of the material change to determine if it crosses to MEC status.

As you can see, some of this can get pretty technical and just reading the actual language in the tax code itself is difficult for the layman to decipher without the aid of a tax expert. But for those of you who wish to tackle the paragraphs in question they are found in the modified endowment contract rules Section 7702A. Ironically, even the tax experts of the Necessary Premium Task Force of the Society of Actuaries’ Taxation Section has reported, as recently at 2012, that there are no regulations describing the NPT (the necessary premium test) in the code, “a circumstance not unusual where sections 7702 and 7702A are concerned.”5 Yet in a private letter ruling by the IRS, dated June 14, 2011 and released to the public on September 16, 2011, the Service not only clarified the ruling but also reached a conclusion that was consistent and logical with the original authors of the TAMRA rules. This most recent IRS ruling has actually helped insurance carriers track the MEC technicalities with even greater precision.

CONCLUSION

The good news is that today each policy that is issued will have its own MEC premium limit already calculated by the insurance carrier, so that if an owner attempts to make a premium payment that would result in the reclassification of the policy as a MEC, the company can hold the money temporarily and warn the owner before it actually happens. This is a huge advantage and relief for policy owners who have no idea that these IRS guidelines exist, especially when practicing IBC, or for those wishing to do so.

Additionally, now with the Authorized IBC Practitioner’s Program and the Practitioner Finder at Infinitebanking.org, policy owners can have a double safeguard by being able to consult with a trained IBC financial professional beforehand, or in a case where a premium payment would trigger the MEC status and the company is requesting authorization to proceed or send a refund. For these and other important reasons an Authorized IBC Practitioner should always be consulted for implementing IBC policies.

Finally, we should not lose sight of what is really going on here. The IRS has stepped in here at a crucial time in history for a reason and I have devoted this article to making that reason clear. The notion that Whole Life insurance is the “worst place to put your money” should now appear ridiculous. Prudent and middle-class Americans should take careful note that as long as you stay within the rules, the strategy of the wealthy is still available to you, your household, or your business.

Naturally, each individual’s circumstances are unique, requiring a specialized financial plan. No decision should be made without input from a qualified professional. Yet the reader’s choices should take into account the material I have presented in this article. In an economic environment filled with chronic inflation, onerous taxation, and erratic market volatility such as we have today, the decision to move your wealth from the volatile Wall Street/commercial bank nexus into the conservative, safe, insurance sector via a specially designed IBC policy carries tremendous advantages.

References

  1. Becoming Your Own Banker, Copyright 2000, R. Nelson Nash, Infinite Banking ,LLC, Birmingham, AL, Page 38
  2. Nixon Shock, Wikipedia article on the closing of the gold window. http://en.wikipedia.org/wiki/Nixon_Shock
  3. The Tax Reform Act of 1986, Wikipedia article, http://en.wikipedia.org/wiki/Tax_Reform_Act_of_1986
  4. Modified Endowment Contract (MEC), Legal Information Institute, Cornell University Law School, Contract Defined, http://www.law.cornell.edu/uscode/text/26/7702A http://www.irs.gov/irb/2008-29_IRB/ar16.html
  5. Article From Taxing Times on the MEC, Society of Actuaries, By John T. Adney, Craig R. Springfield and Adam C. Harden, February 2012-Volume 8 Issue 1, Taxing Times–May 2013 – Society of Actuaries