Congress established a statutory definition of life insurance in 1984 in IRC Section 7702 that was a significant step in eliminating the favorable income tax treatment of investments disguised as life insurance. Nevertheless, it was not the end of congressional tinkering with the tax laws applicable to life insurance. In 1988 Congress further tightened the tax rules that apply to life insurance by creating an additional test to identify cash value-rich life insurance contracts.
Under these expanded rules governing the taxation of life insurance, any life insurance contract becomes a modified endowment contract (MEC)and is subject to less favorable income tax treatment if it fails to meet the 7-pay test.
A life insurance policy is said to fail the 7-pay test and therefore becomes a MEC if the total premiums paid by the policy owner in the first seven years exceed the amount of premiums that would have been required to make the policy paid up in seven years. If a life insurance policy that has previously met the 7-pay test undergoes a material change in its benefits or terms, the life insurance policy is treated as though it were a new contract entered into on the day the material change took place, and the 7-pay test must be met again.
If a life insurance policy is deemed to be a MEC, that status cannot be changed. Once a policy is considered a MEC, it is always a MEC.
Under a life insurance policy that has met the 7-pay test and therefore is not a MEC, distributions are taxed on a first-in, first-out (FIFO) basis. Because premiums are always deemed to be paid into a life insurance policy before any earnings are credited, FIFO tax treatment of cash value distributions results in distributions being considered a tax-free recovery of the policy owner’s basis before any earnings are distributed. The net effect of that tax treatment is that withdrawals from the policy are tax free until they exceed the policy owner’s basis in the contract. Policy loans on a non-MEC policy are income tax free.
In a life insurance contract that fails the 7-pay test and therefore is a MEC, its cash value grows on a tax-deferred basis until distributed, but its distribution tax treatment changes from FIFO to last-in, first-out (LIFO). Under LIFO, all earnings are deemed to be withdrawn before any basis is recovered and are income taxable. As a result, any gain on the contract at the time a withdrawal is made is deemed to be received first. Only after the gain has been received will the remainder of the withdrawal be tax free. Also, if the policy owner is under 59-1/2 years of age, not only are earnings income taxable, but they are subject to a 10% penalty. Policy loans on a MEC policy are income taxable and subject to the 10% penalty, if applicable.
Death benefits are not usually taxable in either non-MEC policies or MEC policies.
If you have an Infinite Banking policy, you should avoid it becoming a MEC. On the other hand, if you are working with a competent agent, you should not be concerned with your policy suddenly becoming a MEC and having to pay taxes. If the 7-pay test is violated, you will have 60 days after the end of the contract year to reverse the situation by taking the extra money back out, and all insurance companies give plenty of advanced notice of any reclassification as a MEC.
MEC policies are usually purchased by individuals who are interested in tax-sheltered investment-rich policies where they do not intend to make pre-death policy withdrawals, so they can pass on significant sums of money to their beneficiaries. They can also be used as gifts to tax-exempt organizations.
If you would like to learn how you can grow a substantial amount of cash that you have access to at any time without penalties, is unrelated to the stock market, and will generate income that is not included in your tax return, visit our website at http://InfiniteBankingSimplified.com/ or feel free to email us your questions at ContactUs@InfiniteBankingSimplified.com or call us toll-free at 1-844-443-8422.
Isis B. Palicio, LUTCF, MBA
Pedro A. Palicio, MBA, Ph.D.
Infinite Banking Concepts® Authorized Practitioners