Life Insurance loans to avoid MEC

[Sophia Edwards]

I have 2 clients that each want to deposit $100,000 into a life insurance policy. They are early 50s. They want to have the option of taking loans and paying same back into policy. I was told that even taking a loan would trigger a MEC. They want Whole Life policies - Both in excellent health. Any suggestions?

 

[DHK]

Yes. Learn about whole life insurance.

In order to avoid MEC status, the policy must satisfy the 7-pay test. These aren't bank accounts. There are requirements in order to preserve the tax status of these policies.

Now, you can structure these policies to have high first year cash values, but they will require ongoing premiums.

Here's a video worth reviewing:

 

[DHK]

Here's another good one:

 

[Allen Trent]

I have 2 clients that each want to deposit $100,000 into a life insurance policy. They are early 50s. They want to have the option of taking loans and paying same back into policy. I was told that even taking a loan would trigger a MEC. They want Whole Life policies - Both in excellent health. Any suggestions?

I think you have it backwards. Loans dont trigger a MEC. a Policy is a MEC when it violates the premium guidelines. Once a MEC always a MEC, meaning from that point forward you will be taxed on the 1st dollars taken out as you have to take the gains out first unlike a non-MEC where you can withdrawal/borrow the cost basis tax free.

NOTE: Withdrawals, Loans, even pledging the policy as collateral to a bank all trigger a MEC taxable event along with ownership changes triggering a taxable event. Some agents dont realize loans from the MEC are an issue but even more agents have no idea that assigning the policy as collateral to a bank or an ownership change can trigger taxable distributions

 

[LostDollar]

NOTE: Withdrawals, Loans, even pledging the policy as collateral to a bank all trigger a MEC taxable event along with ownership changes triggering a taxable event. Some agents dont realize loans from the MEC are an issue but even more agents have no idea that assigning the policy as collateral to a bank or an ownership change can trigger taxable distributions

(caveat, not an agent)

Ooops! I just stepped in a bear trap!

- Is the tax on the gain between premium and face?
- Who is liable for it?
- I know nothing about gift tax exclusions. Do you know if they could enter into ameliorating the tax effect of this issue?
- Website posting or IRS pub that would give some basic understanding of the issue?

Thanks.

 

[scagnt83]

(caveat, not an agent)

Ooops! I just stepped in a bear trap!

- Is the tax on the gain between premium and face?
- Who is liable for it?
- I know nothing about gift tax exclusions. Do you know if they could enter into ameliorating the tax effect of this issue?
- Website posting or IRS pub that would give some basic understanding of the issue?

Thanks.

The tax is on the Cash Value, minus Premiums.

Usually, the donor is liable for any Gift Taxes owed. (the gift tax was created to stop people from avoiding the estate tax)

Most likely they could. The GT Exclusion has been $15k for the past 4 years, and is $16k this year. Often gifts are split up over a number of years to keep them under the Exclusion. With Life Insurance, you could put someone as Co-Owner and that would probably suffice for being 50% of the CV. Some carriers will break up Ownership into %s, but seems like moot point for your current situation... Talk to your tax professional about filing necessary forms. Even if Ownership was transferred a few years back, you can still go back and file an amended return most likely.

Frequently Asked Questions on Gift Taxes | Internal Revenue Service

 

[Allen Trent]

Is the tax on the gain between premium and face?

No. any tax due is on the gain in the policy is not related to the face amount. it is all driven by what is called the adjusted cost basis. Cost basis for most people is indeed their premium payments as their "investment" into the policy. But in some cases if policies have riders on spouses or other riders, those premium payments were for term coverage & not considered part of the investment in the cost basis of the cash value. so that establishes 1 part of the equation as to what you have into your cost basis.

the other part of the equation is how much you have gained over that cost basis. Most believe it is merely the cash value of the policy. However, you are also considered to have already received some of the values if you have taken money out & the most dangerous is all the interest charged on policy loans is also considered to have been value you have received. So, a person that paid $20k into a life policy with a current $3,000 cash surrender value, took out $10k as a withdrawl & also took out say a $10k loan that 30 years later has now grown to a $30k loan would have the following:

$20k cost basis minus $10k withdrawal for a net current cost basis of $10k
Total received would be $33k ($30k outstanding loan & $3k surrender value)

Could owe taxes on $23k in current tax year even though they likely think they lost money & dont owe anything. the loan interest over the years can catch a lot of people by surprise if they knee jerk surrender or if the policy lapses for no value (this is why many current produc t versions have overloan protection to keep a policy from lapsing........but there is no protection for a consumer that surrenders ignorantly. most agents dont share these details as many dont know the tax trap of a compounding loan

Who is liable for it?

owner of the policy at the time the 1099 goes out

I know nothing about gift tax exclusions. Do you know if they could enter into ameliorating the tax effect of this issue?

not following completely pertaining to this MEC or taxable gain discussion. Gift tax exclusions are an unrelated topic that generally allow the giver to not owe gift taxes on up to 15k annually in gifts or a 1 time hit to your lifetime exclusion by filing a current gift tax return. neither the giver or the gift recipient owe income taxes on a gift. (now, if you cash out something that has a taxable event before you give it, then sure you would owe current tax depending on where you got the money to give away).

Currently, if you are talking about changing ownership on an asset while alive as a gift, it can many times be better to have it be a gift at death depending on the asset. currently, house, land & after tax brokerage account get a step up basis at death. if you instead gift that while you are alive, the recipient takes over your lower cost basis & loses the step up in cost basis at your death along with you possibly owing gift taxes currently if the asset is over $15k, etc.

Website posting or IRS pub that would give some basic understanding of the issue?

too many topics you mention for 1 IRS publication or article to cover. However, in terms of the taxable event of life insurance loans when a policy lapses, here is a great article I recall reading in the past: Life Insurance Policy Loans: Tax Rules And Risks (kitces.com)

 

[Allen Trent]

The tax is on the Cash Value, minus Premiums.

I learned my lesson about 10 years ago giving that simple answer for a relative with a Northwestern Mutual old, old life policy. current CV was $5k & they had paid $20k, so I said no gain. call the company & ask for current taxable gain. Luckily they did because they had an outstanding loan of almost $40k merely because they had quit paying the premiums years ago & the policy was borrowing from itself to pay the premiums. the dumbest part was they had sizeable PUAR values & a big dividend on a 2nd policy & sizeable dividend on this current policy . Both of those could have been used to cover the premiums rather than the loan that had created such a large taxable gain in the other policy if surrendered or lapsed. They were able to start redirecting annual dividends to pay down the loan balance. But, as you can imagine, they were not thrilled to possibly owe thousands in taxes on gains merely for charged interest on the loan

 

[marindependent]

These aren't bank accounts.

I wish more life insurance agents knew this.