With stocks at record levels, many investors may worry prices are more likely to fall than to rise. And some who are casting about for an alternative may be presented a little-known option: the modified endowment contract, a kind of cash-value life insurance policy valued for its investing features rather than the death benefit.
But experts urge caution, as these contracts don’t always work as well as cash-value policies that don’t have this designation.
“A modified endowment contract is typically viewed as a life insurance policy that has gone bad because it was overfunded and does not allow tax-free withdrawals in the form of a loan,” says Len Hayduchok, president of Dedicated Financial Services in Hamilton, New Jersey.
Modified endowment contracts share many of the tax benefits afforded annuities, except they do not become taxable upon the death of the policyholder. A policy becomes a modified endowment contract if it receives payments exceeding those required for the death benefit.
[See: 7 of the Best Stocks to Buy for 2018.]
“A MEC is not a specific investment that you can compare to other investments,” says Richard P. Sabo, owner of RPS Financial Solutions in Gibsonia, Pennsylvania. “It is actually a life insurance policy that has tripped certain government limits on how much you can put into it, and once you trip those limits, it becomes a MEC.”
Avo Mavilian, president of Tailwind Financial Strategies in Houston, says, “[Modified endowment contracts] are cash value permanent life insurance contracts that don’t qualify for favorable tax treatment of withdrawals from the contract because they have violated federal tax laws.”
While that sounds bad, Mavilian says these contracts can be useful for investors who want tax-deferred compounding and don’t really intend to make withdrawals during their lifetimes. But that comes with the risk of facing taxes and penalties on withdrawals before age 59.5 if things don’t turn out as planned.
“Generally speaking, you see these accounts held by individuals with significant assets, including business owners, those reaching retirement, and already retired,” Mavilian says. “With the need for (funds for) long-term care and chronic illness, a MEC may be a powerful strategy to protect individuals in retirement because of the leverage modern day life insurance policies may provide.”
Before buying a policy that could be classified a modified endowment contract, find out how soon you will be able to withdraw money, how much you’ll be able to take without a surrender charge, and how it will be taxed. Also make sure you know the size of the death benefit and that your heirs won’t be hit with tax.
And, of course, look at options for investing the cash you put in beyond the premium requirements. Is a minimum return guaranteed? Will you have enough investing choice at the start, and as your needs and market conditions change?
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
A few things to keep in mind:
Money is tied up. Modified endowment contracts work best for investors who do not plan on making withdrawals before turning 59.5, else they get hit with the same tax and 10 percent penalty applied to early withdrawals from an individual retirement account or 401(k).
Modified endowment contracts were created in the 1980s as Congress clamped down on insurance policies set up to skirt taxes on investments.
“The government was trying to get people to put money away for their retirement and keep it tied up until then, so they started to do away with some of the loopholes that gave you access prior to retirement,” Sabo says.
Death benefit. As with traditional life insurance, the death benefit goes to beneficiaries tax free.
The seven-pay test. A policy becomes a modified endowment contract if premiums paid over a seven-year period exceed a limit determined by the death benefit and policy holder’s age — essentially, the amount required for a policy to be paid in full. Investors should study their policy to make sure they’re following the rules.
Withdrawal taxes. Since 1988, federal law has required that modified endowment contract withdrawals be reported on a last-in first-out basis. That typically means withdrawals first count as taxable investment earnings subject to income tax rates rather than a non-taxable return of principal. Some investors may consider this a disadvantage if they could instead get the lower long-term capital gains rate on something else. Previous rules allowed first-in, first-out withdrawals, so that money removed was a tax-free return of principal.
Mistakes. A mainstream policy may be deliberately converted to a modified endowment contract. But it can also happen inadvertently if arcane rules are violated, and that may not be in your best interests. “Not all people selling life insurance truly understand this,” Mavilian says. “And worse, when clients make changes in the future, oftentimes the original agent is not there to help them navigate.”
Life insurance policies used as investments can be complex and confusing for people accustomed to buy-and-hold mutual funds.
“Those who own life insurance should do an annual review and also ask for an ‘in-force illustration'” showing how planned investments are working out, Mavilian says.
[See: 7 Ways to Invest for Income.]
“In addition, anytime a policyholder wants to make withdrawals, they should contact a qualified professional for assistance,” Mavilian says.
More from U.S. News
7 Stocks Primed for an Amazon.com, Inc. (AMZN) Buyout
The Top 10 Investment Portfolio for Millennials
7 of the Best Tech Stocks to Buy for 2018
The All-Inclusive Guide to Modified Endowment Contracts originally appeared on usnews.com
