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Single-Premium Life Insurance and MECs
With most big-ticket items, such as a home or an automobile, there are typically two ways to complete the purchase: you pay cash, or you finance it. But did you know you have the same options when it comes to buying permanent life insurance?
Most people are familiar with paying regular premiums for life insurance, whether it is a term or permanent policy (such as whole life insurance). But although the option is infrequently discussed, it is possible to buy a life insurance policy with just one cash payment. The product is called Single-Premium Whole Life (SPWL).
How SPWL works
Suppose a healthy non-smoking 45-year-old man wants to buy $100,000 of whole life insurance. Most people would consider a policy with annual premiums, scheduled to be paid for one’s entire life (hence, the term “whole life”). Although the premiums might vary slightly depending on the insurance company, a representative whole life policy from a reputable (mutual company) insurer would be $1,970/yr. (This example assumes no additional features or riders, such as waiver of premium, are added to the policy.)
However, if the man happened to have significant savings, he could also consider making just one premium payment – of $31,180 from a reputable company that offers such a product. That single payment would guarantee the insurance would remain in-force for the rest of his life, no matter how long he might live.
Paying just one premium not only secures the insurance benefit, but dramatically changes the cash value accumulation. Here are the hypothetical cash-value accumulations* for the whole life and single-premium whole life. (These hypothetical values assume a certain level of dividends credited and that such dividends were assumed to be used to buy paid-up additions, Dividends are never guaranteed.)
As you can see, the cash value at the end of the second policy year exceeds the original premium. (The cash value of the whole life policy is not projected to exceed premiums paid until the 13th year.)
In simplest terms, a single-premium whole life policy is an asset transfer. The buyer is exchanging one asset (bank savings, shares of stock, bonds, etc.) for the values and benefits of another (permanent cash-value life insurance).
“Once upon a time…”
If you are familiar with the unique characteristics of permanent cash value life insurance, you might think, “hey, I could see some attractive advantages to purchasing a single-premium policy.” And before 1988, you would have been right. But that was before changes in the tax law introduced the Modified Endowment Contract.
Prior to 1988, a single premium policy was treated like any other life insurance contract that had cash value. The cash values accumulated on a tax-deferred basis, and at death the proceeds passed tax free to the beneficiary. If the cash value accumulation was needed, it was available to the policyowner through tax-free lifetime loans or withdrawals. With single-premium policies, it was possible to place large amounts of cash as a single deposit, and investors often used SPWLs in place of other investment vehicles in which the earnings or liquidation were subject to income or capital gains taxes.
As some cash value life insurance policies (such as SPWLs) started to appear more like tax-favored investments and less like insurance, lawmakers chose to limit or eliminate the tax advantages. New tax laws enacted in 1988 defined insurance policies that were funded too rapidly (generally in one large payment) as Modified Endowment Contracts (MECs), and eliminated the use of such policies as short-term savings vehicles by imposing stiff penalties.
SPWLs are still offered by life insurance companies, and these policies may still be a good fit for appropriate situations. But the MEC guidelines have greatly reduced the use of SPWL in most financial programs. And since MEC guidelines apply not only to SPWLs, but all life insurance policies, consumers need to be aware of the possible impact of MEC in their financial programs.
The MEC Rules
First, there is taxation on cash values. Under the current law, money taken from a MEC in the form of policy or premium loans, partial surrenders, assign-ments, pledges, withdrawals, or loans secured by the policy are subject to income tax and, in some instances, additional tax penalties (such as withdrawals or loans taken before age 59½). The tax is imposed on a last-in, first-out (LIFO) method. In a non-MEC policy, withdrawals are treated as a return of premium, so any tax is applied last, and only to amounts in excess of premiums paid.
A policy that was not a MEC when issued can become one if it becomes “over-funded” at a later date. The rule determining whether a life insurance policy has become a MEC is known as the “7-pay test.” According to Forefield.com, a company that provides information to financial professionals, the 7-pay test “is a limitation on the total amount you can pay into your policy in the first seven years of its existence. The test is designed to discourage premium schedules that would result in a paid-up policy before the end of a seven-year period.” But the 7-pay test is also a rolling calculation, so even policies that were non-MECs in the early years can become MECs later (possibly through extra premium payments or even greater-than-projected dividends).
However, while a non-MEC policy can become one at a later date, once a policy is a MEC, it can never revert to non-MEC status – even if the policy is changed, adjusted, or reconfigured so that it would not otherwise be considered a MEC if it was a new contract. Even a non-MEC policy received in exchange for a MEC is also considered a MEC.
Why You Should Care About the MEC Rules
Because many investors have suffered substantial losses in various investments over the past two or three years, permanent life insurance has been “rediscovered” by some financial commentators as a stable, attractive asset class. This has prompted greater interest in using permanent life insurance for accumulation, particularly in policies which offer options for depositing additional premiums, most of which are applied directly to the cash value accumulation.
In some ways, this approach is akin to making a regular whole life policy function like a pre-1988 single-premium policy. One commentator who advocates maximum cash value accumulation while retaining all the withdrawal features of a typical whole life policy puts it this way: the goal is to “snuggle up to the MEC line – but don’t cross it!”
This approach is legal, and may be suitable for individual situations. But it also requires attention and management! Insurance companies are aware of the potentially negative consequences of having a policy classified as a MEC, so they are scrupulous about monitoring the status of each policy. In addition, policyowners have 60 days to rescind transactions that would cause a MEC to occur. But the burden is on the policyowner to respond to the notifications.
What about Your Situation?
If you have whole life insurance policies (or are considering adding them to your financial program), you may want to explore ways to maximize the cash value accumulation through additional premium payments and dividend options. But make sure your discussion includes an awareness of the MEC limits and the potential penalties.