Single premium policies were considered the ideal savings vehicle. This led to the development of the PUA rider. Including a paid-up additions rider with your whole life insurance policy is crucial if your financial goal is to grow as much cash value inside your insurance policy as possible without it becoming a Modified Endowment Contract.
A PUA rider allows you to overfund your policy right up to the line of it becoming a Modified Endowment Contract, maximizing your cash value and interest-earning potential. The majority of the PUA premium paid is immediate cash value. When structured properly with a PUA rider, whole life insurance competes with market-based investments in terms of returns, but offers much more protection against market volatility. The IRS has a lot of ways in which it can regulate how much money you put into savings vehicles.
With life insurance, the IRS has created the 7-pay limit, which is a per-policy measurement. That is determined by your insurance company. You can also take out insurance policies on anyone whose death would affect you financially. This is called insurable interest. You can insure family members, business partners, employees, or anyone whose loss will inflict justifiable financial loss. Multiple policies within a family are collectively referred to as the family bank or private family banking.
This strategy is used to grow family wealth and to create a legacy that can be passed down for generations. In rare circumstances will you overpay your premium. Once a policy becomes a Modified Endowment Contract, it will always be a MEC, which is why this change of contract is so serious. However, if your life insurance policy is properly structured, you should never have to worry about your policy entering into a Modified Endowment Contract.
After reading about all the advantages of a whole life insurance policy compared to a Modified Endowment Contract, it might seem like a MEC is a bad thing to have. Personal Finance. Your Practice. Popular Courses.
Insurance Life Insurance. What Is a Modified Endowment Contract? Key Takeaways A modified endowment contract MEC is the term given to a life insurance policy whose funding has exceeded federal tax law limits. What are the likely tax consequences of a early withdrawal under an MEC? How are taxes on gains figured in an MEC? Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Related Terms Single-Premium Life Insurance Single-premium life insurance charges the policyholder just one lump-sum premium payment to guarantee the death benefit.
What Is Section of the U. Tax Code? Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Cash-value life insurance has always provided consumers with a tax-free avenue of growth within the policy that could be accessed at any time, for any reason.
But Congress has placed limits on the amount of money that can be put into these instruments, and all cash-value policies are now subject to what is the seven-pay test also written as the "7 pay test" , which limits the tax benefits of cash-value withdrawals. Policies that fail this test are now classified as modified endowment contracts MEC. Tax-free growth is one of the chief advantages of cash-value life insurance , and therefore many life insurance carriers tried to take advantage of this feature in the late s by offering single-premium and universal life products that featured substantial cash-value accumulation.
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. This act created the MEC. 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 the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. Any policy that receives premiums in excess of these limits automatically becomes a MEC. In a general sense, the corridor rule states that for any life insurance policy to avoid being classified as an MEC, there must be a "corridor" of difference in dollar value between the death benefit and the cash value of the policy. All single-premium policies are now classified as MECs.
Flexible-premium policies must pass the seven-pay test in order to avoid MEC status. This test caps the amount of premium that can be paid into a flexible-premium policy over a period of seven years. Once a policy has been classified as an MEC, it cannot regain its former tax advantages under any circumstances. The MEC classification is irrevocable. Each policy that is now issued will have its own MEC premium limit that is based on several factors, including the age of the policy owner and the face amount of the policy.
Any premium paid into the policy in excess of this limit will result in reclassification of the policy as an MEC. A Little Background MECs originated in the late s, after interest rates on cash value life insurance policies had hit a jaw-dropping 20 percent. What Is the 7-Pay Test? What Are the Tax Implications?
Related Product Life Insurance. Was this article helpful? Related Articles. Discussing Life Insurance for Your Spouse. On Your Own? Life Insurance for Children or Grandchildren?
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