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

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

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.

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)".

Marking distribution code 1 in box 7 indicates to the IRS that my gain (the taxable amount in box 2A) is subject to the additonal 10% tax penlaty for early distribution (line 60 of form 1040).

My question is whether what the insurance company put in box 7 is correct?

The letter I got from the insurance company when I surrendered my policy said that the transaction I requested (i.e., surrendering my policy) could result in it becoming a MEC and that if it turned it into a MEC the additional 10% tax penalty would apply since I was less than age 59-1/2. The wording of the letter was fuzzy, but the way the insurance compnay filled out the form 1099-R was not.

I have found information about MECs that discusses the 7 year test and material changes, but nothing that says that surrendering a (whole life) policy automatically makes it a MEC or that surendering a (whole life) policy is a material change that triggers a new 7 year test which results in making it a MEC.
 
Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

I have never heard of a 10% penalty on a life policy surrender, only on an annuity policy surrender before age 59 1/2.
 
Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

Again, please tell us the company and the policy name (not yours). You could have a dividend paying whole life, an interest paying whole life, a Universal life, a variable life or something else... Somewhere you should have something that tells us what the policy is. (i.e. a XXX farm extra life)

It is really hard to offer you any help without this information. Also some questions would be

Was the premium flexible?
Did you overfund it?
did it over perform?
Did you reduce the face amount?
did you rollover cash values from another policy to start this one?

The MEC 7 test is a continous test for the life of the policy. At any point where your cash values approached the mec classification, the carrier should have communicated with you.

Any information you can provide would help. I don't want to know who you are, but I do want to know what company and policy you had and if you did anything other then pay a premium.

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

No one is going to be able to answer your questions directly here, just speculate on the causes. Call the carrier and/or the agent and ask for an explanation. Something doesn't sound right here.
 
Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

I have never heard of a 10% penalty on a life policy surrender, only on an annuity policy surrender before age 59 1/2.

This is tax law, not someone or some company's decision.

The reason that you haven't seen this is due to the fact of the expense load and the cost of the insurance, against what they have deposited into the policy. In most cases the net returned to the policy holder upon surrender is less than the basis; hence NO tax liability.

A definition of an MEC:

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

If they have greatly underfunded the policy, then I can see the surrender amount being less than the basis. If they have funded it adequately, there is probably a gain in the policy and tax would be due on the surrender.

Again, I have never heard about a 10% penalty on a life insurance policy surrender. Please provide the tax code that states this. Can anyone here back me up on this? My understanding of the tax code is that there is not a 10% penalty on a life policy surrender. But...I am not a CPA.
 
Re: Does surrendering a whole life policy that was not previously a MEC make it a MEC

If they have greatly underfunded the policy, then I can see the surrender amount being less than the basis. If they have funded it adequately, there is probably a gain in the policy and tax would be due on the surrender.

Again, I have never heard about a 10% penalty on a life insurance policy surrender. Please provide the tax code that states this. Can anyone here back me up on this? My understanding of the tax code is that there is not a 10% penalty on a life policy surrender. But...I am not a CPA.

IRS Code is Sec 7702A... But if I were you I would rather read english version of same.

Modified Endowment Contract (MEC)
Created in 1988 through an Internal Revenue Code (TAMRA Section 7702A), the MEC was created to prevent policyholders from using cash-value policies like universal or whole life solely as a source of tax-favorable loans. A life insurance contract becomes a MEC when, during the first seven years or when any material change is made, a policyholder's premiums exceed a specified limit known as the "7-Pay Limit." The limitations of a MEC include taxation of loans or withdrawals, and an additional 10% penalty tax for withdrawals made by the policyholder prior to age 59½.

Try this link... it is not the tax code, but a chart about MEC's +'s and minuses, from CCH.

CCH Financial Planning Toolkit | Modified Endowment Contract (MEC) Basic Features
 
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