A Modified Endowment Contract (MEC) is a life insurance policy issued on or after June 22, 1988, which fails the seven-pay premium test. The test period starts at issue and lasts seven years; a new test period starts whenever the life policy incurs a material change. A policy can also be a MEC if the policy was issued on or before June 20, 1988, if it has had a material change (i.e. increased or exchanged) and fails the seven-pay test, within seven years after the date of the change. Once a policy becomes a MEC it will always remain a MEC. Under a MEC, distributions are included in taxable income up to the amount of gain in the contract. Any gain is deemed to be distributed before the investment in the contract. Gain is the difference between the cash surrender value before reduction by any surrender charge and the policyowner’s investment in the contract. Investment in the contract basically equals the premiums paid less any prior distribution received tax-free. Policy loans from a MEC would also be considered a taxable distribution unlike a policy which is not a MEC. In addition, there is a 10% IRS tax penalty applied to the amount of any pre-death distribution from a MEC that is includable in gross income. There are three exceptions to this additional tax: 1) The taxpayer is at least age 591⁄2; the taxpayer has become disabled or 3) the distribution is part of a series of substantially equal periodic payments, such as an annuity, over the lifetime of the taxpayer. Section 7702A(b) defines the seven-pay test as follows: “A contract fails to meet the seven-pay test of this subsection if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums which would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.” The information presented here is not intended as tax or other legal advice. For application of this information to your client’s specific situation, your client should consult an attorney.
Death benefit options
Death Benefit Option A (level) and B (increasing) Death benefit proceeds, which are the amount payable to the beneficiary upon the death of the insured, equal the death benefit (as defined below for the selected option) minus any policy loan balance and any lien balance. The cost of insurance rate is applied only to the net amount at risk, which equals the death benefit (discounted for one month at the fixed account guaranteed interest rate) less the account value. For all options, regardless of the death benefit option in effect, the death benefit may be adjusted upward to make sure the policy qualifies as life insurance under federal tax law. Death Benefit Option A (level) The death benefit payable is the specified amount of insurance. Death Benefit Option B (increasing) The death benefit payable is the specified amount of insurance plus the account value. This is a larger death benefit than Option A. A larger premium is required to accumulate the same cash value as in Option A, since the amount of pure insurance remains constant.
For financial professional use only. Not for use with clients.
IUL-AG-0723
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