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Modified Endowment Contract

• What is a MEC - Modified Endowment Contract?
  The federal tax law definition of "life insurance" limits your ability to pay certain high levels of premiums. In addition, if your cumulative premium payments exceed certain amounts specified under the Internal Revenue Code, your policy will become a Modified Endowment Contract (MEC). If your policy is a MEC, the tax treatment of any death benefit provided under the contract will still qualify for income tax free treatment but you may be subject to additional taxes and penalties on any distributions from your policy during the life of the insured.

  You can ask your financial professional to provide you with an illustration of policy benefits that shows you the amount of premium you can pay, based on various assumptions, without exceeding these tax law limits.

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• What policies are "grandfathered" from becoming Modified Endowment Contracts?
  Life insurance contracts entered into before June 21, 1988 are generally "grandfathered" from this premium limit test. However, certain changes made to the contract could invalidate the policy's "grandfathered" status and subject it to premium limit testing.

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• What changes could cause a loss of "grandfathered" status?
  A face amount increase, the addition of a rider or an increase in its amount, a reduction in rating, a change to non-smoker status or a substitution of insured are all considered material changes and could result in a loss of "grandfathered" status. With the change, a new 7-pay period is started effective with the date of the transaction and a new 7-pay premium is determined. Premiums will need to be limited to the 7-pay premium for seven years following the change in order to avoid Modified Endowment Contract (MEC) status.

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• What is the effect of a MEC (Modified Endowment Contract)?
  If your policy is a MEC (Modified Endowment Contract) the tax treatment of any death benefit provided under the contract will still qualify for income tax free treatment. However, you may be subject to additional taxes and penalties on any distributions from your policy during the lifetime of the insured. Any distribution from a policy that is a MEC will be taxed on an "income-first" basis. Distributions for this purpose include a loan (including any increase in the loan amount to pay interest on an existing loan or an assignment or a pledge to secure a loan) or withdrawal. Any such distributions will be considered taxable income to you to the extent there is gain in the policy at the time of distribution. That is, the distribution will be includible in income up to the amount your account value exceeds your basis in the policy.

  A 10% penalty tax also will apply to the taxable portion of most pre-age 59 1/2 distributions from a policy that is a Modified Endowment Contract.

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• When will the 10% penalty apply to a distribution from a MEC?
  A 10% penalty tax will apply to the taxable portion of most distributions from a policy that is a Modified Endowment Contract.
  The penalty tax will not apply to:

  • distributions to taxpayers whose actual age is at least 59 1/2,
  • distributions in the case of a disability (as defined in the Code) or
  • distributions received as part of a series of substantially equal periodic annuity payments for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and his or her beneficiary.

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• How is MEC status determined?
  A Modified Endowment Contract (MEC) is a life insurance policy that has had cumulative premium payments made during the first seven years that exceed a limit defined in the tax code. This limit is called the 7-pay limit and depends in part on the amount of the policy's death benefit and the age of the insured. At any point in time during the first seven policy years, premiums paid cannot exceed the sum of the annual 7-pay limits or the policy will become a MEC. This means your total limit will increase each of your first seven policy years. After seven years, MEC testing will not apply unless at any point in time a "material change" requires your policy to start a new 7- pay testing period with new 7- pay limits.

  Whenever there is a "material change" under a policy, the policy will generally be (a) treated as a new contract for purposes of determining whether the policy is a Modified Endowment Contract and (b) subjected to a new 7-pay period and new 7-pay limit. Material changes include: a face amount increase, the addition of a rider or an increase in its amount, a reduction in rating, a change to non-smoker status or a substitution of insured and all could result in a loss of "grandfathered" status.

  There are also changes considered reductions in benefits during a 7-pay test period that trigger a retroactive recalculation and testing of premiums. A reduction in benefits during a 7-pay test period causes the policy to be retested as if the policy had been issued at the reduced level of benefits. This could cause the policy to become a Modified Endowment Contract based upon premiums paid prior to the reduction in benefits.

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• What is the "basis" in a life insurance policy?
  Your basis, sometimes also referred to as your investment in the contract, generally will equal the premiums you have paid, less the amount of any previous distributions from your policy that were not taxable. For Modified Endowment Contracts, your basis is also increased by the amount of any prior loan under your policy that was considered taxable income to you.

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• What are taxable events?
  If your policy is not a MEC (Modified Endowment Contract):

  • Upon full surrender, any amount by which the proceeds we pay (including amounts we use to repay any policy loan and unpaid loan interest) exceed your basis in the policy will be includible in income.

  • • If a policy terminates after a grace period, the repayment of any then-outstanding policy loan and unpaid loan interest will be treated as a distribution and could be subject to tax to the extent the distribution exceeds your basis in the policy.
    • If you make a partial withdrawal during the first 15 years of your policy, all or part of the withdrawal may be taxable if there is gain in your policy, even if the withdrawal does not exceed the cost basis.
    • If you make an assignment of rights or benefits under your policy and the policy is a MEC or subject to a policy loan, you may be deemed to have received a distribution from your policy, all or part of which may be taxable.
    • If you reduce your benefits under a policy, it is possible that amounts previously paid as premiums will exceed the amount the tax law permits for your policy to be treated as life insurance. This could cause amounts to be forced out of the contract to keep its qualification as life insurance. These force-outs could be required at the time of the reduction and/or in future years. All or a portion of any amounts forced out may be taxable to the extent there is gain in your policy.

  All amounts includible in income under a life insurance policy will be considered ordinary income as opposed to capital gain. If your policy is a MEC, any distribution from your policy will be taxed on an "income -first" basis. Distributions for this purpose include a loan (including any increase in the loan amount to pay interest on an existing loan or an assignment or a pledge to secure a loan) or withdrawal.

  A 10% penalty tax also will apply to the taxable portion of most pre-age 59 1/2 distributions from a policy that is a Modified Endowment Contract.

  AXA Advisors does not provide legal or tax advice. You must consult your legal and tax advisors for specific advice pertaining to your situation.

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