Does surrendering a whole life policy that was not previously a MEC make it a MEC?

[jornal]

Does surrendering a whole life policy that was not previously a MEC cause it to become a MEC?

In October 1988 I signed up for a whole life policy. I paid my monthly premiums for many years with the understanding that I could take out cash (cash value or dividends) up to the amount of premiums I had paid without any tax consequences and that anything I took out beyond the amount of premiums I paid would be taxable.

In May 2006 I decided to surrender my policy. The insurance company sent me a check and a letter. The new letter said that by surrendering my policy I had turned it into a MEC and since I was less than age 59-1/2 the 10% tax penalty would apply to my taxable gain. Later the insurance company sent me and the IRS a form 1099-R (Distribution from pensions, annuities, retirement or profit sharing plans, IRAs, insurance contracts, etc.) showing the gross distribution (box 1), taxable amount (box 2A), and distribution code 1 (box 7) "early distribution, no known exception (under age 59-1/2)".

I have looked at everything I could find on the internet about MECs. I have read about the 7 year test and material changes. I passed the initial 7 year test. I never did anything with my policy other than pay the monthly premium until I surrendered it so I don't think I had a material change to my policy before I surrendered it. Did surrendering my policy turn it into a MEC (and thereby make my gain subject to the additional 10% tax)? If so, how and why?

Thanks
Jornal

 

[STIBROKER]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

try,,,,,, modified endowment contracts......................

 

[jornal]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

I know that MEC stands for modified endowment contract. I forgot to write it out before the first time I used the acronym in my original message.

I have searched for "modified endowment contract" on the internet and could not find the answer to my question. That's why I came to this forum for help.

Jornal

 

[LGilmore]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

Who was the policy with? Also check your policy dates with when the mec provision was passed. Did you overfund it at any time? Did it pay dividends or interest? It would help if we knew the policy type.

 

[HomeService]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

This type of deal is most commonly related to UL -and not whole life policies. And usually when too much money is accumulated in cash value. Thus, I would say it is possible that some sort of dividend had been repaid { or paid really} into the policy at some time- or something or other.

 

[Winter_123]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

Does surrendering a whole life policy that was not previously a MEC cause it to become a MEC?

In October 1988 I signed up for a whole life policy. I paid my monthly premiums for many years with the understanding that I could take out cash (cash value or dividends) up to the amount of premiums I had paid without any tax consequences and that anything I took out beyond the amount of premiums I paid would be taxable.

In May 2006 I decided to surrender my policy. The insurance company sent me a check and a letter. The new letter said that by surrendering my policy I had turned it into a MEC and since I was less than age 59-1/2 the 10% tax penalty would apply to my taxable gain. Later the insurance company sent me and the IRS a form 1099-R (Distribution from pensions, annuities, retirement or profit sharing plans, IRAs, insurance contracts, etc.) showing the gross distribution (box 1), taxable amount (box 2A), and distribution code 1 (box 7) "early distribution, no known exception (under age 59-1/2)".

I have looked at everything I could find on the internet about MECs. I have read about the 7 year test and material changes. I passed the initial 7 year test. I never did anything with my policy other than pay the monthly premium until I surrendered it so I don't think I had a material change to my policy before I surrendered it. Did surrendering my policy turn it into a MEC (and thereby make my gain subject to the additional 10% tax)? If so, how and why?

Thanks
Jornal

There are a couple factors there. One is that you can take out funds without tax as long as the policy is still in effect. The entire face amount is tax free if paid at death and the funds that you take early are treated as a loan against that face amount if taken out early. Obviously this scenario all falls apart if you surrender the policy. The government then has just let you grow funds tax deferred and then take them out, essentially as a modified endowment contract because there is no longer insurance death benefit to go with it. So, it treats them as a mec and applies the penalty and taxation.

The other thing is that the taxable amount is determined obviously by finding out how much increase there has been to the funds beyond the basis, the amount you paid in. Your analysis assumes that the amount that you paid in premiums is the basis. It isn't. Part of your premiums went toward paying for the underlying cost of insurance and part toward the investment/cash value of your policy. Only the second part of that equation is your basis. The statements from the insurance carrier should break this down.

Winter

 

[ims01]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

If the policy lapses or surrenders while the insured is alive, taxes are due on gain. Had you kept the policy inforce and borrowed (above basis) against it, you would not have owed tax as long as you died with the policy still in force. The outstanding loans would have reduced the death benefit.

CYA: I am not a CPA and this my understanding of how the current tax law works.

 

[bluemarlin08]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

Call the company and have them explain the reasons. Ask for their legal department if you can't get answers.

 

[JMO Fan]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

There are a couple factors there. One is that you can take out funds without tax as long as the policy is still in effect. The entire face amount is tax free if paid at death and the funds that you take early are treated as a loan against that face amount if taken out early. Obviously this scenario all falls apart if you surrender the policy. The government then has just let you grow funds tax deferred and then take them out, essentially as a modified endowment contract because there is no longer insurance death benefit to go with it. So, it treats them as a mec and applies the penalty and taxation.

The other thing is that the taxable amount is determined obviously by finding out how much increase there has been to the funds beyond the basis, the amount you paid in. Your analysis assumes that the amount that you paid in premiums is the basis. It isn't. Part of your premiums went toward paying for the underlying cost of insurance and part toward the investment/cash value of your policy. Only the second part of that equation is your basis. The statements from the insurance carrier should break this down.

Winter

MECs are overfunded UL contracts. Once UL is a MEC, surrender or loan amounts are taxed first, to the extent of overfunding. Not true of WL.

Loans are not taxed when taken. Cash "taken out" via partial surrender could be, but WL usually won't permit this. But on surrender, the total amount of loans and accumulated interest is added to cash surrender value to figure the taxable amount received.

WL basis = premium paid

WL gain = (taxable amount received) - basis

WL premiums paid do not exclude any "cost of insurance" element.
You should get a 1099 from the insurer at year-end which will tell you how much is taxable. The taxable amount must be declared on your Federal Income Tax return.

I learned this the hard way. I had two WL contracts (one par, one non-par) with max loans, one year I couldn't afford the interest, so they were terminated. I intended to reinstate, but didn't get it done in the same calendar year, forgot about it when I did my taxes. IRS adjusted my filed return (and tax due) for the amount of gain from both policies.

 

[loginname]

Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

By my understanding of the tax law, Winter's 2nd paragraph is not correct. I am not a CPA though.