Mike and Mindy's MEC
As we do not sell products at Life Insurance Strategies Group, our team has become quite popular with attorneys seeking to validate insurance case designs brought to them by their clients. In most of these situations, a lawyer is caught off-guard by not having been included in the initial life insurance search and then having their client show up with a proposed life insurance product and structure.
Meet Mike & Mindy
Recently, a local attorney, Natalie, called to chat about her clients, Mike and Mindy and the MEC (“Modified Endowment Contract”) whole life insurance policy they had been proposed by a captive agent of a mutual life insurance company. The policy proposal was for second-to-die, joint-survivorship contract paid for with a single premium of USD 2.5m to fund a face amount of USD 20m.
Natalie was at least pleased Mike and Mindy were considering some planning since Mindy had recently sold her chain of pet food stores and, both aged 42, they still had two children under the age of 10. The lawyer recognized this was just the start of the process and any life insurance policy would need to be owned inside of a trust, among numerous other planning details to be sorted.
The part Natalie did not understand was the suggestion of the captive agent that the face amount was USD 20m and the policy should be a single premium MEC. Her estate and wealth planning work with Mike and Mindy would come up with the appropriate insurance number; however, in the meantime, Natalie wanted some advice on the MEC design. Maybe that was the route to take but as she said over the phone, “I’m a lawyer and not a life insurance expert.”
What is a MEC?
A MEC is a tax definition of a life insurance policy which has been funded with more money than allowed under federal tax laws. A life insurance policy which obtains this funding level is no longer considered life insurance by the IRS, but instead, it is considered a modified endowment contract.
Broadly, what this means to the owner of a MEC is that the death benefit will be received tax-free and the cash value will grow tax-deferred, but any attempt to make withdrawals or loans of the cash value will result in a tax on the growth over premiums paid at the policyowner’s ordinary income tax rate.
Worse, a LIFO (last in, first out) accounting method is applied to the withdrawals or loans so that the basis in the policy—the premiums paid—is the last money out of the policy. Essentially, a MEC is much like an annuity with a tax-free death benefit and, like an annuity, there is a 10% penalty on pre-age 59 ½ withdrawals and loans.
A client buying a MEC should not be expecting to access the policy cash value except in an emergency.
Clients buy MECs for a number of reasons and, often, when addressing estate planning, the ability to apply a one-time premium for an amount of insurance that is less than then the amount of insurance a non-MEC policy requires to be compliant (usually in three or more annual premium payments—no single premiums) is attractive. In other words, the life insurance transaction is handled all at once for lower insurance costs than alternative designs. Maybe this is what Mike and Mindy need?
“It is not,” Natalie said after hearing about the taxation on accessing the MEC policy’s cash values. “Mike and Mindy have wealth but not so much where they can lock up such a large single premium for the rest of their lives. I think they have under-estimated the educational expenses of their children and, as an entrepreneur, I know Mindy might need capital to start a new venture.”
To MEC or not to MEC
It was clear Mike and Mindy might be better served with a non-MEC policy which permits the access of policy cash values via a loan which is tax-free as long as the policy remains in force. Such a policy will require a slightly higher amount of death benefit than a MEC and must be paid for according to an IRS test, resulting in three or more (roughly) annual premiums.
Natalie was perplexed the agent recommended a MEC because the agent had the same information about Mike and Mindy and their liquidity.
Unfortunately, this was a common situation of a commission driving the recommendation. A single premium will result in a ‘heaped’ (up-front) commission of around 10% of a whole life insurance policy single premium—or at least USD 250,000 in this instance—for the agent.
A more sophisticated life insurance producer with a substantial practice and reputation to protect would most likely not have made such an ethical lapse.
“I work with a number of life insurance producers who specialize in high net worth clients but I did not want to refer one of them in before validating the situation and having a ‘he said, she said’ situation to confuse Mike and Mindy,” said Natalie. “I’m now perfectly comfortable bringing in someone else to sit down with them after seeing this recommendation for what it is.”
It may be Mike and Mindy end up with a MEC policy; albeit, for a smaller amount and/or making more premium payments where a large amount of capital is not tied up. Natalie promised to reach out for a review of the new recommendation when all her planning work is done and when Mike and Mindy sit down with a more professional life insurance producer.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.