Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.
Question: My client is interested in doing a tax-free Section 1035 exchange of a life insurance policy for a new one. The existing policy has substantial cash value. Will the transfer of that cash to the new life policy create a modified endowment contract (MEC)?
Answer: A transfer of cash value from a non-MEC existing contract to a new one, by itself, will NOT cause the new contract to become a modified endowment contract.
If a taxpayer buys a new permanent life policy, depositing premiums in excess of the seven-pay limit during the policy’s first seven years will cause the contract to become a MEC. Distributions from MEC policies during the policy owner’s lifetime are taxed less favorably than those from “normal” life policies.
A Section 1035 exchange is treated as a material modification rather than a new policy purchase for the purpose of the seven-pay test. That means that the money rolled over is not treated as new premium, but rather as existing cash value for MEC testing purposes. The new contract will be subject to seven pay testing, but the cash value will simply act to adjust the seven pay limit for the policy’s first seven years.
It is still possible for the new exchanged contract to become a MEC if
- The old policy was a modified endowment contract at the time of exchange,
- Dividends, unearned premiums or other cash were transferred as part of the exchange process, or
- New premiums are deposited into the new contract in excess of the modified seven pay limit.
While cash values transferred as part of the Section 1035 process are not considered new premiums for seven pay testing purposes, they ARE considered new premiums for federal guideline premium purposes.
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