Modified Endowmentsand the clients who love them…

Jerry BorrowmanCLU, ChFC, MSFS, CAP, LUTCF

Intermountain Financial Group, LLC

For Producer use only. Not for use with the Public

CRN#201111-127269

• Neither MassMutual nor any of its employees or agents are authorized to give legal or tax advice. Clients should consult their own personal attorney, legal or tax counsel for advice on specific legal and tax matters.

• As a MassMutual representative, you are not authorized to provide tax advice. You should encourage your clients to speak to their tax advisors if they have specific tax questions about their policies.

Key Benefits of Life Insurance

• Death Benefit—the primary reason to purchase life insurance.– Whether whole life, universal life, first or second-

to-die, best practices dictate that clients should only purchase life insurance when there is a valid need to provide beneficiaries with a death benefit.

• Cash values—a secondary benefit that may become important to clients as their needs and desires change.

Non-MEC and MEC

• In 1988 Congress passed TAMRA, legislation which included a new definition of life insurance:Two categories: 1. Policies that are not considered “Modified Endowment

Contracts” (Non-MEC) • Traditional premium paying policies are considered non-MEC

policies. Generally, these are policies that are funded over a longer period.

2. Policies that are considered “Modified Endowment Contracts.” (MEC)• Policies that accept premiums that violate the “7-Pay Test” for

early funding are classified as modified endowment contracts.

Key points about Non-MEC policies• Income tax-free death benefit paid to

beneficiaries• Premiums are paid with after-tax dollars*• Cash values accumulate tax-deferred

– Dividends used to purchase paid-up additions also accumulate tax-deferred.

• Surrender of policy values (including paid-up additions) reduce basis and are not taxable until cumulative withdrawals exceed basis.

• Policy loans are nontaxable when taken. – Net cash value and death benefit is reduced by outstanding

loans– At surrender, the loan is treated as part of the proceeds

distributed. A loan can create a taxable distribution even where there is almost no net surrender value.

* Pension plan owned policies can be non-MEC and are paid with pre-tax premiums.

A partial list of uses of non-MEC policies

• Death Benefits:– Cash to pay bills at death; invest proceeds to provide income

to survivors; estate liquidity; allow participants in a defined benefit pension to take a single life income for maximum income while maintaining a death benefit to provide an income to a surviving spouse; estate equalization; estate taxes; estate buy-sell; charitable bequests; family legacy through multi-generational trusts; key person for business, etc.

• Cash Values:– Dividend surrenders or cash withdrawals to supplement other

retirement income; tax-free policy loans for emergencies or opportunities; executive benefit planning, etc.

What is a Modified Endowment Contract?• A policy becomes a Modified Endowment

Contract (MEC) when it meets all requirements of Code Section 7702 but fails the 7-Pay Test of Section 7702(A).– The 7-Pay test applies to all policies issued

after June 21, 1988*

• In other words, it qualifies as life insurance, but with different tax treatment for lifetime withdrawals.

* A policy issued before that date can lose grandfathering for certain increases in or additions of benefits.

The 7-Pay Test• The 7-Pay test involves a 7-pay limit also known as the “TAMRA Limit”

or MEC limit.– This is an annual amount that if violated reclassifies the policy as a

MEC– It is cumulative – if the client pays less than the limit in the first

year s/he can catch up in later years. The reverse is not true.• MassMutual tests policies when premiums are received and on certain

events to determine if the policy will become a MEC.– A warning is created if a particular premium pattern creates a MEC. – If the client chooses not to withdraw excess premiums the policy will be

identified as a MEC on company records with future taxation of lifetime withdrawals reported as such. The client must agree to this in writing.

– Once classified as a MEC, the classification cannot be reversed• Material changes may cause a policy to be re-classified as a MEC.

Material changes include changes in the face amount, addition or termination of a term rider, etc.

Opportunities to use a MEC• Periodic Premiums – Periodic Premiums to the ALIR Rider to enhance cash

accumulation and net death benefit.• Single Premium– Final expense multiplier– Single premium policies as gifts of a paid-up policy on

the lives of grandchildren– Clients who need insurance for traditional reasons but

hate to pay ongoing premiums– A large single premium to the ALIR Rider in whole life

or survivorship whole life policies to enhance cash accumulation and death benefit

– A single premium to a UL-Guard 2 or SUL-Guard to create a large guaranteed death benefit for beneficiaries with nominal cash value.

Key Points about MEC policies• A policy may be re-classified a MEC anytime during its existence. Special

restrictions on cumulative premiums apply in the first seven years and after any material change.

• MEC contracts still enjoy the benefits of tax-deferral and a tax-free death benefit.

• Taxation of MEC’s is different from non-MEC Life policies as follows:– Withdrawals or loans are taxed on a “Last In – First Out” basis (LIFO).

This means that any gains are withdrawn first.– Gains are subject to ordinary income tax in the year of withdrawal. If

there is no remaining basis in a non-MEC, withdrawals are taxable as gain.

– Taxable gains taken prior to the owner’s age 59 ½ are subject to a 10% surtax (penalty) in addition to the full amount being included as taxable income.

– Loans are considered distributions and are taxable to the extent of gain. • Taxable loans increase basis to make sure that, if repaid, the gain is

not again taxed.• Interest that accrues to the loan is considered a new loan and may be

subject to taxation to the extent of gain remaining in the policy.

7-Pay Test: Cumulative

7-Pay Test: Okay to catch up

7 Pay – Does this pass MEC test?

Single premium policies…

A single premium policy will always fail the 7-Pay test and therefore be classified as a MEC

• Clients should be fully informed of what this means.

• In many instances this remains a positive way to solve the specific need identified.

Who fits a MEC

• There are generally two distinct types of clients looking to purchase life insurance: – Maximum cash value

• Clients who typically hold their cash assets in guaranteed accounts and who do not want to risk losing principal.

• The primary purposes of the MEC policy is to maximize cash accumulation with an income tax-free transfers to heirs.

– Maximum death benefit with little or no cash value• These are often created using a secondary guarantee

universal life policy or second-to-die universal life policy with little or no cash accumulation.

How to design a MEC

• For those who want cash– Typically, these clients will select a whole life policy with the minimum

face amount, so that most of the single premium is applied to the ALIR (Additional Life Insurance Rider) to purchase Paid-Up Additions. ALIR paid-up additions have guaranteed cash value in addition to the base policy and that is eligible for non-guaranteed dividends, as declared.

– Second-to-die whole life policies can also be used to enhance cash accumulation.

• Non-Guaranteed Dividends– Purchase additional paid-up additions,– Paid out in cash to the client each year to provide a modest income,

while preserving the life insurance cash value and benefits for future needs and for heirs, subject to gain-first taxation and 10% if the owner is under age 59 ½ when the withdrawal is taken.

An example:

• Male Age 65 with $250,000 of non-qualified money and wants life insurance.

• Qualifies for life insurance• Desires tax-deferral and guarantee of principal• Doesn’t anticipate spending money from this

fund, but wants to keep it “just in case”– The following comparisons look at a high early

cash value whole life policy, survivorship whole life.

High Early Cash Value Whole Life as of 10/15/2009. $100,000 base, excess to buy paid-up additions (ALIR) in the first year. Premiums on the base policy are paid with APO/ALIR surrenders in subsequent years.

Yr Age

Out-of-Pocket Premium Current Cash

Value

Current Death Benefit

1 66 $250,000 $243,689 $523,830

5 70 $0 $303,606 $554,303

10 75 $0 $389,887 $605,810

20 85 $0 $628,325 $765,457

35 100 $0 $1,194,809 $1,194,809

HECV Whole Life Male Age 65 – Ultra Preferred. $100,000 Base Face Amount, balance to ALIR. Hypothetical Current Values which assume premium is paid with Alternate Premium Option in Year 2-35. This slide must be accompanied by a complete MassMutual policy illustration and distribution of this slide to the public is prohibited. Dividends are NOT guaranteed. Values as of October, 2009

Survivorship Whole Life as of 10/15/2009. $100,000 base, excess to buy paid-up additions (ALIR) in the first year. Premiums on the base policy are paid with APO/ALIR surrenders in subsequent years.

Yr Age

Out-of-Pocket Premium Current

Surrender Value

Current Death Benefit

1 66 $250,000 $242,965 $671,334

5 70 $0 $304,668 $714,499

10 75 $0 $406,774 $788,480

20 85 $0 $710,877 $1,023,329

35 100 $0 $1,369,906 $1,559,387

Male and Female Age 65 – Ultra Preferred. $100,000 Face Amount. Hypothetical Current Values. This slide must be accompanied by a complete MassMutual policy illustration and distribution of this slide to the public is prohibited. Dividends are NOT guaranteed. Values as of October, 2009

Maximize Death Benefit

• Clients who are not concerned about cash accumulation can apply the single premium to universal life or survivorship universal life.

• Consider two examples:

UL Guard-2 as of 10/15/2009.

Yr Age PremiumCurrent Cash

ValueCurrent Death

Benefit

1 66 $250,000 $188,432 $856,831

5 70 $0 $151,848 $856,831

10 75 $0 $45,322 $856,831

20 85 $0 $0 $856,831

35 100 $0 $0 $856,831

UL-Guard 2 Male Age 65 – Ultra Preferred. Solve for Face Amount using a $250,000 single premium. This slide must be accompanied by a complete MassMutual policy illustration and distribution of this slide to the public is prohibited. Dividends are NOT guaranteed. Values as of October, 2009

Survivorship Universal Life-GUARD as of 10/15/2009.

Yr Age Premium

Current Death Benefit

1 66 $250,000 $203,043 $1,295,389

5 70 $0 $213,493 $1,295,389

10 75 $0 $197,848 $1,295,389

20 85 $0 $0 $1,295,389

35 100 $0 $0 $1,295,389

Male and Female Age 65 – Ultra Preferred. Face Amount Solve with $250,000 Single Premium This slide must be accompanied by a complete MassMutual policy illustration and distribution of this slide to the public is prohibited.

Single Premium MEC Alternatives$250,000 Single Premium: Male Age 65 UP. Female 65 UP.Rates as of 10/2009

Yr AgeHECV WL

NSVSurvivor WL NSV

UL Guard 2

NCV

SUL Guard

NCVHECV NDB

Surv. WL NDB

UL Guard 2

NDB

SUL Guard NDB

1 66 $243,689 $242,965 $188,432 $203,043 $523,830 $671,334 $856,831 $1,295,389

5 70 $303,606 $304,668 $151,848 $213,493 $554,303 $714,499 $856,831 $1,295,389

10 75 $389,887 $406,774 $45,322 $197,848 $605,810 $788,480 $856,831 $1,295,389

20 85 $628,325 $710,877 $0 $0 $765,457 $1,023,329 $856,831 $1,295,389

35 100 $1,194,809 $1,369,906 $0 $0 $1,194,809 $1,559,387 $856,831 $1,295,389

MEC vs. Non-MEC

Many producers and clients continue to ask a very basic question about MECs, “How much does it matter if a policy is classified as a MEC?” Although there is no way to answer this question definitively, the following may help to clear up some misconceptions and explain why virtually all clients should carefully weigh the pros and cons, and consider potential unanticipated events, before deciding to accept a MEC. Basically, two areas require some clarification regarding the impact of MEC status:

MEC vs. Non-MEC

1. TaxationThere are two key disadvantages of a MEC that apply without

regard to the owner’s age. First, unlike non-MECs, distributions come out as income-first, making them taxable for any policy having gain. Second, policy loans are treated as distributions, as distributions, again making them taxable for any policy having gain. This taxation significantly reduces the value of the MEC policy’s accumulated cash value to its owner.

2. Tax PenaltyTaxable distributions from a MEC are subject to a 10%

additional tax unless an exception applies

Conclusion

• Life insurance creates a death benefit. That is the primary purpose to purchase life insurance.

• Whole life policies have guaranteed values and are eligible for non-guaranteed dividends that clients may value.

• Secondary Guarantee UL policies create a fully guaranteed death benefit where cash accumulation is nominal.

• Taken together, these products can help clients reach their financial objectives.

Questions?