Don’t Overfund Your Life Insurance Until You Understand This | MECs Explained

Hey, it's Demetrius. I lead the end asset team here at Better Wealth. And in this video here, we're just going to be talking about modified endowment contracts or MEX for short. So let's hop right on into it. First and foremost, the first question that we need to answer is what exactly is a modified endowment contract? And this is important because it comes up pretty often in most of our conversations that we're having with clients is that what is this whole idea of a modified endowment contract, especially when we're talking about it in relation to overfunding whole life insurance. policy. And so if you're looking into using life insurance as a wealth building tool, or as just want to incorporate it in your overall growth strategy, understanding the impact of a policy that's classified as a MAC is actually incredibly important. So let's start off with a little bit of a history lesson first, and let's take you back to 1980s and prior to that. So leading up to the 1980s, a lot of high income individuals, they were using life insurance as a legal tax shelter. They'd pour large sums of money into policies. These policies would have very little death benefit. And it wasn't because they needed the life insurance in and of itself, but it was because it gave them a way to grow tax deferred money and access it tax free. Right. And so Congress eventually kind of stepped in and they said, hey, you're doing too much here. This is enough. We're going to step in and we're going to make some rules. We're going to put some some walls. some parameters between what you guys are doing here. And so in 1988, they passed the Tamra Act, which introduced a new rule to prevent insurance from being used as an investment-like vehicle with little to no death benefit, pretty much, or small amounts of death benefit. And this rule became known as what we call modified endowment contracts. And just for the sake of clarity, life insurance is not an investment, but it's an incredible place to save money, grow money. use your money, especially when you're thinking about where you want to keep a lot of your money safe, right? And so it's not really out there for all of the risk and all of that sort of things, although that kind of exists. Typically, what we're talking about here is safe money, safe money storage, okay? Now, when you hear MEC, when you hear M-E-C, think about this. Think about too much money, too fast. But let's kind of expound on that even a little bit further here. This isn't a 401k. This isn't like a Roth IRA where there's fixed contribution limits across the board universally for everyone. That isn't how these life insurance policies work. And to get a little bit more specific on that, that may be a whole nother video in terms of what each individual's limitations are or contribution limits are, but we won't talk about that in this video. But the IRS just limits how much premium can be put into each individual policy in relation to the death benefit on each individual policy, especially in the early years. And so they run what's called a... seven pay tests, which really just checks to see if you funded the policy way too aggressively over those first seven years. Again, in relation to the policy's death benefit. If you go above, if you go over the allowable limit, the policy ends up becoming what's called a modified endowment contract. And that changes how the IRS sees your policy from a tax perspective from that point forward, right? Because once it becomes a MEC, you can't go back from it. So Here's why all of this matters. When you have a policy that is not a MEC, you get tax-deferred growth, you get tax-free access through policy loans, and up to a certain point, even with withdrawals, and then there's no early withdrawal penalties either. But if a policy becomes a MEC, this is where, for most people, it just kind of is not the best move, especially if the goal is tax-free access and things of that nature. If the policy becomes a MEC, you're... gains, especially when you go to access that money is going to be taxed on a LIFO basis or last in first out instead of a FIFO basis, which stands for first in first out. Another, you know, another component of a policy actually being a MEC is that withdrawals before the age of 59 and a half. You know, if you do that, you may have to, you may be contending with also a 10% penalty as well. And then when a policy is also a MEC, again, even your loans themselves. can be taxed, which usually loans are not considered taxable inside of the IRS. But for modified endowment contract policies, those loans can also be taxed. So even though it's still life insurance. For tax purposes, it behaves more like a retirement account when you're specifically referring to the cash value in and of itself. I hope that makes sense. Now, the seven-pay test, I'm packing that a little bit more. It's how the IRS determines whether a policy becomes a MAC. It sets a limit on how much premium can be paid over a seven-year period based on, again, the policy's death benefit. I want to reiterate that. If you ever go over that limit, Again, at any point whatsoever, the policy will be classified as a MEC and it's going to stay that way forever. And this is why proper structure matters so much. And so speaking of structure, people talk about properly structured life insurance. They talk about specially designed life insurance. Like this is what we're all talking about when we say these things, because we're talking about it in reference to the modified endowment contract to make sure that it doesn't become that because we want to keep all of the tax advantages. of the cash value that come with policies that are set up properly. Hey guys, I just want to interrupt real quick. If you're watching this and have an index universal life policy, a whole life policy, have any type of insurance policy in general. And you're like, I want to know if I'm on the right track. I want to know if this is set up properly. We at Better Wealth want to help you. We want to give you a free policy analysis and show you, are you on the right track? Is there some things that you potentially could be doing better? And so we have a link down below that you will have access to. We would encourage you if you have a policy and you want to see if you're on the right track, check that out. And if you're someone that's watching this and you're like, I want to talk to someone, maybe setting up a policy for myself, or I have questions, we would love to serve you. You can also see a link to have a call with someone on our team back to the episode. So it's not a matter of just throwing money into a policy at random. Okay. We are literally engineering the policy to get it very close to that MEC limit without necessarily crossing that limit. The reason we're doing this is because it retains your tax advantage status of your policy. Okay. Now, a lot of times in this world, we live in binaries. It's like yes or no, good or bad, right or wrong. Nothing wrong with that in and of itself. Nothing wrong with binary thinking per se. But I think oftentimes we say, well, if what you're saying here, Demetrius, is that mechs are bad things. and The answer to that would be no, not necessarily, especially if you're a nonprofit, if you're a foundation, you have some sort of tax exempt entity, maybe a church or whatever that may be. These organizations are often already exempt from income tax from the very beginning anyway. So the usual penalties that come along with MEC policies don't really apply. Okay. So what this means is that they can use a MEC policy to store capital still. access that cash value and not have to worry about necessarily some of the tax consequences that would come with a typical MEC for someone that is not a nonprofit, a foundation, or some other sort of tax-exempt entity. And so for those entities, a MEC could make a lot of sense. You know, whether the goal might be maximizing cash value, whether it's the maximizing the death benefit, or you're just trying to do a combination of the both. The key is knowing your goals and designing the policy. in accordance with those goals. All right. And so here's the bottom line, just to wrap everything up. A MEC happens when you put too much money, too much premium into a policy too quickly, again, relative to the death benefit in and of itself, which ultimately changes how the IRS treats the policy for tax purposes. For most individuals, avoiding MEC status is really going to be a really crucial piece, especially if you want tax-free access to your cash value throughout your lifetime. But for certain entities, right, tax exempt ones, MECs can be powerful. It can be a powerful thing in your strategy. And there may even be worlds where potentially a MEC could make some sense for a non-tax exempt entity as well. But that's a video for a whole nother day. So either way, my point is structure is everything. And that's why we build policies in such a way that gets you real close to the MEC limit, but we never are crossing it unless, of course, there's a good reason to. do so specifically. So if you want to learn more about how these policies are designed or whether it could be a good fit for you and your financial goals now, medium term, long term, whatever, check out the link in the description. I believe there might even be a pinned comment as well to book a call with our team and we'll be happy to help. Thanks for watching.