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Avoiding The Modified Endowment Contract Trap !

In the 1970s, many life insurance carriers took advantage of the tax-free growth their cash-value policies provided by offering products that featured substantial cash value accumulation. Policy owners could withdraw interest and principal as a tax-free loan from these policies, effectively making them large tax shelters. Congress passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) to counter this use. And TAMRA created the Modified Endowment Contract (MEC) classification. To avoid MEC status, flexible-premium policies must pass the seven-pay test, which caps the amount that can be paid into the policy over a period of seven years. Any policy that receives premiums in excess of those limits becomes an MEC. New policies now include their own MEC premium limits, which expire after seven years. The MEC classification is irrevocable, meaning the policy cannot regain its former tax advantages. But unused cap space can accumulate. For example, if a policy has an MEC limit in the first year of $5,000, and only $4,000 in premiums is paid, the extra $1,000 carries over to the second year’s premium limit. Before the MEC law debuted, withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. That meant original contributions that represented a tax-free return of principal were withdrawn before any earnings. TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive FIFO tax treatment. Loans and withdrawals from MECs are taxed on a last-in-first-out basis, so any taxable gain the policy creates is reported before the non-taxable return of principal. The IRS also imposes its own rules for how cash-value policies can retain their FIFO status. Read more: Avoiding The Modified Endowment Contract Trap - Video | Investopedia http://www.investopedia.com/video/pla... Follow us: Investopedia on Facebook