Tax Implications of Modifying a Modified Endowment Contract

 

A modified endowment contract (MED) is a non-taxable cash value life insurance contract within the United States wherein the total premiums paid on a contract have exceeds the predetermined amount allowed for the full tax treatment of an ordinary life insurance policy. This means that the amount invested on the contract will be available as taxable income under the provisions of the estate tax law. In general, the more expensive a contract, the less potential it has for growth since the premium payments are subject to a minimum rate of return. Also, as with all insurance contracts, the death benefit and face amount may be capped or restricted.

There are several reasons why a person would purchase a modified endowment contract. Some examples of these reasons include an attempt to protect the family of the insured while also providing an additional source of income during retirement. An additional reason is that tax rules often allow individuals to borrow against the death benefit on a modified endowment contract to fund education or other similar goals. Another commonly cited reason is that premiums that would be included in regular beneficiary endowments may be excluded in a modified endowment contract. Also, there may be an option in certain contracts to increase the death benefit beyond the existing guaranteed minimum benefit. While some insurance providers limit the increase of the death benefit, other providers allow for an unlimited increase.

One important thing to remember about a modified endowment contract, as with any life insurance policy, is that the benefit is limited to a single beneficiary only. Furthermore, the contract must comply with all applicable Federal and state laws and regulations. An example of these laws and regulations are: the "cliff-edge" provision, in which a policyholder elects to exclude all future annuity payments from their death benefits; the "low-risk" provision, which allows for a higher risk premium than a standard life insurance policy; the "one-time" provision, which allows a policyholder to sell a portion of the contract to another individual within a fixed time frame; and the "limited service" provision, which prevent a policyholder from cashing in one's annuity benefits for their own use. While these provisions can seem complicated, they are crucial to understanding a modified endowment contract. Visit here for free consult.

One important issue to take into account when evaluating whether a modified endowment contract would be appropriate for your needs is the provision relating to the provision allowing for the death benefit to exceed the death benefit provided under the policy. Generally, when an individual coverage under an existing term policy, there is no requirement that the policyholder to give up any future death benefits in exchange for obtaining modified coverage. However, if you decide upon this alternative and then choose not to cash-out before the end of the term, it may create a tax issue. If you are paying premiums for a term policy and decide to cash-out before the policy expires, you will receive a taxable distribution. This is why it is important to evaluate your options carefully before making your final purchase. If you have other options, and if the premium for a term policy is significantly more than the death benefit of the modified endowment contract, it may be in your best interest to go with the term policy, despite the potential tax consequence.

Another important issue to take into consideration when considering modified endowment contracts relates to the classification of dividends received under the contract. Many individuals purchase life insurance policies for investment purposes, expecting to receive a lump sum of money upon the death of the policyholder. However, if the policyholder is not alive at the time of the sale, there are some problems that may arise. For example, suppose you die as the result of an automobile accident. Under the terms of the modified endowment contract, your beneficiaries will receive the entire face value of the policy, even though the accident occurred during the time period specified in your original contract.

The important thing to remember in all of these examples is that the modification of an existing policy provides no tax benefits to the beneficiary of the policy, and there are tax consequences associated with the transfer of monies received under the modified endowment contract. These consequences become significant if the beneficiary does not obtain the full face value of the policy at the time of its sale. If this occurs, then the whole life insurance policy will lose its tax-deferred status and will be treated as a single lump sum distribution. Again, if you are considering modifying your life insurance contract for tax reasons, it is a good idea to discuss your options with a qualified financial advisor who can provide advice on which options will be best for you and your family. Visit here to schedule consultation.

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