Modified Endowment Contracts

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Modified Endowment Contracts


Modified endowment contracts were created in 1988 as the result of Congress attempting to curb the use of a popular life insurance tax shelter. Life insurance had been blessed by Congress with tax-free growth, tax-free death benefits, and tax-favored withdrawals. Many life carriers tried to take advantage of this feature in the late 1970s by offering single-premium universal life products that featured substantial cash value accumulation (these were the predecessors of today’s modified endowment contracts). Policy owners could then withdraw both the interest and principal as a tax-free loan, as long as the policy did not lapse before the owner's death. Of course, this strategy effectively allowed the policy to function as a large-scale tax shelter. Investors were placing their assets into these contracts and were essentially avoiding all taxes on all of the gains forever.

However, Congress did not agree that life insurance should be used in this manner and therefore passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This act created limits on how much money could be placed into life insurance contracts and altered the tax treatment of life insurance policies that were overfunded. These overfunded life insurance contracts became known as modified endowment contracts, or MECs. Before this law was passed, all withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. This meant that the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. But TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive FIFO tax treatment. Any policy that receives premiums in excess of these limits automatically becomes an MEC. Owners of life insurance policies were counseled to avoid overfunding their life insurance contracts in order to maintain preferable tax treatment on their policies. However, for those looking for tax-efficient growth of assets, and not necessarily looking to acquire a life insurance policy, MECs continue to be a very attractive asset.

Tax Treatment:

The MEC still possesses very favorable tax treatment even after the passage of TAMRA. Similar to its cousin the deferred annuity, all interest earned in the contract grows tax deferred. Withdrawals are taxed last in first out. That means that all gains come out first and are taxable as ordinary income. Also gains withdrawn prior to age 59 ½ are taxed at a 10 percent higher rate than normal income. However, the huge tax advantage over deferred annuities occurs at death. Unlike deferred annuities, which are taxable to the extent there are gains in the contract, MECs have an income-tax-free death benefit. New Developments: Although MECs are designed for cash accumulation, they also typically come with a sizable death benefit that exceeds the account value. Since their creation, MECs have been used primarily as wealth transfer vehicles because of their tax-free death benefit. The growth of these contracts has historically been interest-rate sensitive. In times of high interest rates they offered more interest to policyholders, and in times of low interest rates they became less attractive. Also, these contracts typically came with an upfront load and/or surrender charges, which meant the MECs had to be essentially long-term investments. The following are some new developments that have made the MEC even more attractive.

Higher interest opportunity:

Instead of paying interest based on prevailing low interest rates, insurance companies are offering interest rates that are tied to stock indexes like the S&P 500 and the Eurostoxx 50. However, while contract owners may receive double-digit interest in the years the stock markets go up, they don’t lose any interest in the down years. Now, owners of MECs can potentially receive much higher interest than they otherwise would in a low interest rate environment.

No surrender charges:

Another recent development is that a few companies are now offering MECs that have no upfront load and no surrender charges. This means that deposits are essentially liquid and can be removed at any time without any penalty.

Long-term care benefits:

Several insurers are allowing contract owners to receive additional benefits to cover long-term care expenses in the event they suffer a permanent cognitive impairment or are unable to perform 2 out of 6 activities of daily living. This is a very significant benefit as many people today are very concerned about providing for the expenses of future long-term care needs.

Index Crediting Methods:

As mentioned before, the index crediting method provides an opportunity to make higher interest rates than traditional crediting methods in a low interest rate environment. Currently equity index universal life and modified endowment contracts offer more attractive crediting methods than index annuities. It is not uncommon to find contracts that offer annual point-to-point crediting methods with very attractive double-digit caps. Annual point-to-point typically includes a reset feature that will lock in the gains in the “up years” and reset the index value each year. So, in the “down years,” interest is earned from a new, lower starting point. A cap is a limit on the amount of interest that will be credited.

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Modified Endowment Contracts

Learn about modified endowment contracts and how they have impacted life insurance.

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