The cash value will still grow tax deferred and your beneficiaries will still receive the death proceeds income tax free
What is a Modified Endowment Contract (MEC)? The primary purpose of life insurance has always been to help solve the financial needs caused by premature death. Because of its social value, the law has historically given preferential tax treatment to life insurance вЂ“ cash value grows tax deferred, lifetime distributions are treated as a nontaxable return of basis first and then as taxable gain, loans are not taxed when taken and death proceeds are generally received income tax free to the beneficiary.
However, any loans or withdrawals from a MEC will be taxed at the time of withdrawal to the extent of the gain in the policy and may also be subject to a 10% penalty tax
A MEC is a heavily funded life insurance policy which is taxed as an annuity in certain situations. A MEC does not receive all of the tax preferences of life insurance.
As with whole life insurance, the cash value build up of a MEC is tax deferred and the death benefit is income tax free.
Should I purchase a life insurance policy which is a Modified Endowment Contract? That depends on the reasons you want to purchase the life insurance policy. If your primary concern is to protect your beneficiaries from your premature death, the MEC status will probably have little effect. The two major tax advantages remain in place. In addition, payments received under a payment plan will still be taxed on a pro rata basis. However, if you plan to take lifetime distributions (including loans) from the policy, a MEC may not be appropriate.
What constitutes a distribution for Modified Endowment Contract for tax purposes? Distributions that are taxable include: policy loans, premium loans (paid from the cash value), assignments as collateral for loans, annual dividends used to repay loans or loan interest, dividends received in cash, and partial and full surrenders of the policy for cash.
Distributions do not include dividends used to reduce premiums or purchase additional coverage and surrender of paid up additions to pay premiums.
What is the difference between the taxation of distributions from non Modified Endowment life insurance policies and distributions from Modified Endowment Contracts? Distributions from the non MEC life insurance policies are taxed basis first, gain second, while distributions from a MEC are taxed gain first, basis second. The order in which basis is withdrawn is important because basis is not taxable. The following example illustrates the difference.
What if I want to use the cash value of my Modified Endowment Contract to supplement my retirement income?
Assume a policy has a cash value of $10,000 composed of $4,000 of nontaxable basis and $6,000 of taxable gain and a $7,000 distribution is taken. Because a non MEC life insurance policy is taxed basis first, gain second, only $3,000 of the distribution ($7,000-$4,000 (basis)) would be taxed if the policy is not a MEC. However, because a MEC is taxed gain first, basis second, $6,000 of the distribution (the entire gain) would be taxed if the policy were a MEC. An additional 10% penalty tax could also apply to the $6,000 of taxable gain, if the policyowner was under age 59ВЅ.
The contract may still work to your advantage. Withdrawals will still be taxed gain first but will not be subject to the additional 10% penalty tax if taken after you attain age 59ВЅ. Payments taken under a settlement option will be taxed on a pro rata basis and will also not be subject to the 10% penalty tax if taken over your lifetime or after you attain age 59ВЅ.