Advanced Underwriting Consultants

Question of the Day – June 13

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Here’s the question of the day.

Question:  My client owns a MEC life insurance policy that she wants to exchange for an immediate annuity.  What are the tax consequences of doing so?

Answer:  The exchange of a life contract for an annuity is tax-free under Code Section 1035.  That’s true whether it’s a “regular” life contract being traded for an annuity or a MEC that’s being traded.

If a MEC is traded for a SPIA, there’s no tax recognition at the time of transfer.  Each of the SPIA payments will each be partly a recovery of basis (based on the basis from the MEC life policy) and partly ordinary income.

The ordinary income portion of the payments will also be subject to the 10% penalty tax if the taxpayer is younger than 59 ½ and if the SPIA payout period is for a duration shorter than the taxpayer’s life expectancy.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – March 18

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question:  I’m presenting a universal life insurance proposal to a prospect, and am having trouble with explaining guideline premium limits on the illustration.  Can you help sort it out?

Answer:  Most flexible premium life insurance illustrations show three different premium limits for a particular proposal:  guideline single premium, guideline level premium and seven-pay guideline.  These limits are calculated using a number of factors, the most important of which are the insured’s age, the policy’s face amount and the insured’s risk classification.

If the policy owner puts more premium into a life policy than is allowed by the federal guideline premium, the policy is not considered life insurance anymore.  If a policy is not life insurance, the cash value growth each year is taxable, and the death benefit is also taxable.  The guideline premium limit for a given life policy is the greater of the guideline single premium or the cumulative guideline level premium.

These Section 7702 tax results are so severe that life companies do not permit policy owners to violate federal guideline premium rules.

If a policy owner puts more premium into a life policy than is allowed by the seven pay limit, the contract will become a modified endowment contract (MEC).  Lifetime distributions from a MEC policy are treated less favorably from a tax perspective than from a “normal” life policy, but the death benefit would still be income tax free.  Life companies usually do permit their life policies to become MECs.

Here’s an example of how the limits might apply for a particular policy.  Assume that the premium limits shown on the illustration are guideline single ($13,500), guideline level ($1,500) and seven pay ($2,500).  Here’s a chart that helps show how the numbers interact:

Year Guideline Single Cumulative Guideline Level Cumulative Seven Pay
1 13500 1500 2500
2 13500 3000 5000
3 13500 4500 7500
4 13500 6000 10000
5 13500 7500 12500
10 13500 15000 Test ends
15 13500 22500 Test ends

Say that the illustration shows the client paying a one-time premium in the first year of $12,000.  The first test is whether the premium is more than the greater of the guideline single or cumulative guideline level.  While the premium is more than the cumulative guideline level, it is less than the guideline single.  Therefore, the premium is allowable for a life insurance policy.

The second test is whether the premium is in excess of the cumulative seven pay limit.  It clearly is, so the policy will be a MEC.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – November 6

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question:  My 40 year old client is purchasing a life contract that will be a modified endowment contract (MEC).  Can she avoid the penalty tax on distributions by using the Section 72(q) exception?

Answer:  Yes.

Distributions from a non-MEC life contract are considered a tax-free return of basis first, and taxable thereafter.  Distributions from a MEC are taxed on a gain-first basis, and the taxable portion of distributions is also potentially subject to a 10% penalty tax.

Revenue Code Section 72 says that lifetime distributions from a MEC life policy are taxed the same way as lifetime distributions from a non-qualified annuity (NQDA).  Taxable distributions from an NQDA are subject to the 10% penalty tax, unless one of the exceptions of Code Section 72(q) applies.

Section 72(q) makes an exception for the 10% penalty tax where the annuity payments are

part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and his designated beneficiary.

The exception is substantially identical to the Section 72(t) exception to the penalty tax for IRA or qualified plan distributions.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – April 19

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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.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 28

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Here’s the question of the day.

Question: My client owns a life insurance policy that is a modified endowment contract (MEC).  If the client uses the policy as collateral for a bank loan, will the amount of the loan be potentially taxable to the client?

Answer: Yes.

Code Section 72(e) provides the following rule that applies to MEC contracts and nonqualified annuities:

        (A) Loans treated as distributions
          If, during any taxable year, an individual -
            (i) receives (directly or indirectly) any amount as a loan
          under any contract to which this subsection applies, or
            (ii) assigns or pledges (or agrees to assign or pledge) any
          portion of the value of any such contract,
        such amount or portion shall be treated as received under the
        contract as an amount not received as an annuity.  

For a MEC contract, an amount not received as an annuity is taxable to the extent there is gain in the contract.  If the policy owner is younger than 59 ½, the gain portion is also subject to the 10% penalty tax.

If the loan balance grows and the policy continues to collateralize the loan balance, the incremental annual increases in loan value are also potentially taxable distributions.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.