Copyright 2007, The WPI

            It seems that those in the life insurance field have the mind set that allowing a life insurance policy to become a MEC is always bad for clients.  That is not the case and in this newsletter I’ll point out to you with a simple example why intentionally MECing a policy is one of the best ways to buy life insurance for estate planning.

            Modified Endowment Contract (“MEC”)

I’m not going to give a multi-page explanation of a MEC in this newsletter.  If you would like a free summary on MECs, please click here to download it. Instead I’m going to give a quick explanation of what a MEC is and how it can affect a cash value life insurance policy.

As many of you know, one of the unique aspects of a cash value life insurance policy is that once cash is accumulated in a properly designed policy, it can grow tax free and be removed tax free (which is why cash value life insurance can be a good wealth building vehicle).

“Back in the day” before the current MEC rules, clients used to funnel significant amounts of cash into life insurance policies as quickly as possible. Why?  Because the cash can grow tax free and come out tax free in retirement.  “Back in the day” the life insurance policies were designed to have a very low death benefit and the amount of death benefit you were forced to purchase when short funding a policy was very low.

In essence, clients would take lump sum amounts from their taxable brokerage accounts and move that money into short pay or single pay universal life products with very low death benefit coverage.  The clients would then have a significant amount of cash in a very low expense life insurance policy and would allow the cash to grow tax free and remove it tax free in retirement.

As you can imagine, the IRS was not happy about this and eventually Congress passed modifications to Code Section 7702 (the section that provides the tax law definition of a life insurance contract). The modification created Code section 7702A which defines a new class of insurance contracts called modified endowment contracts (“MEC”s). 

In essence the new law requires that insureds who purchase cash value life insurance buy X amount of death benefit depending on how much premium they pay and over what period of time.  The quicker a client tries to pour cash into a life insurance policy, the more death benefit is required.  If the policy becomes a MEC, “tax-free” loans from the policy in retirement are no longer income tax free.

Therefore, what advisors usually counsel their clients to do when funding the MEC minimum death benefit cash building policy is to fund it over a 5-7 year period.  This keeps the death benefit low and in turn the internal expenses of the policy.

When is it a good idea to MEC a policy?

It almost seems strange even to utter the words that it is a good idea to MEC a policy.  When is it a good idea? When the life policies sole purpose is for estate planning. 

IF the client who purchased the policy did so only to have the death benefit pay beneficiaries and had no need for the cash value, there is no need to worry about taxable loans from a policy and therefore, MECing the policy does not cause problems.

Is this a common situation?  Sure. It happens all the time when clients form irrevocable life insurance trusts (“ILIT”) doesn’t it?  While people setup ILITs so a spouse/beneficiary can borrow from a cash value policy owned by the ILIT, as a general statement, ILIT policies are purchased so a death benefit can pass income and estate tax free to the beneficiary.

If we agree that an ILIT policy is purchased for the death benefit, then can we also agree that the client would like to pay the lowest possible premium when purchasing life insurance for estate planning?   I think so.

Question:  Is it less expensive to fund an estate planning life insurance policy over one year, ten years, or twelve years?  The answer is the quicker you can pay the premium when purchasing death benefit, the lower the cost will be.  Don’t believe me? Look at the following real live illustration numbers.

Example:  Assume Dr. Smith is age 66 and in good health.  Assume he can allocate $120,000 to an ILIT and his goal is to purchase the maximum death benefit for his estate plan.  How much “guaranteed” coverage could he purchase?

If he pays a $120,000 lump sum premium, he could purchase a death benefit of $412,464.

If he pays $12,000 a year for ten years, he could purchase a death benefit of $309,843.

If he pays $10,000 a year for twelve years, he could purchase a death benefit of $294,106.

            You can do your own time value of money calculations, but I can tall you that the best financial move for Dr. Smith to maximize his premium dollars is to max fund the premium in year one.   What’s the problem with max-funding a life policy in year one?  The chances are significant that the policy will become a MEC. 

            Insurance agents are told by the industry not to MEC policies because it will get them sued.  Having said that, the above example mandates that Dr. Smith MEC the policy in order to maximize his premium dollars for his ultimate goal which is death benefit NOT cash value or policy loans.

            So again, the question is: when is it a good idea to MEC a life insurance policy?  When the client has no need for policy loans and is purchasing the policy solely to pay a death benefit for estate planning purposes.

            No Cash Value UL

            In case you wondered, the type of policy I used for the above illustration is what I call a no cash value UL (it’s like paid up term life until age 115).  There is cash value in the early years and none in the later years.  It is the least expensive type of “guaranteed” policy a client can purchase and the type of policy I recommend be used in an ILIT the majority of the time.

            Summary on MEC policies

            MECing a policy is not only a good thing, but can be the best way for many clients to purchase a life insurance policy that will be used solely for estate planning purposes.  If the client has no need for the cash, MECing the policy will not affect the client in any way except for the probability that the premiums due to fund for a specific death benefit will be lower due to short funding the policy.