E159: Is a Modified Endowment Contract Best for Your Infinite Banking Goals?

Nate: In this episode, I answer the question, does it ever make sense to own a modified endowment contract, otherwise known as a MEC? We’ll dive into what exactly is a MEC, what are the pros and cons of owning a MEC, and under which situations is a MEC desirable? This is Dollars and Nonsense. If you follow the herd, you will be slaughtered. Well, everyone, welcome back to the show today, I’m taking it solo to discuss the modified endowment contract. So we’re going to be a bit technical regarding what a MEC is, how it applies to the concepts that we promote and so forth. So we’re going to go ahead and just dive into some content.

For those of you who are relatively new to the show, who are maybe new to infinite banking as a whole, and this whole concept, you’ll certainly hear this idea of a modified endowment contract brought up all the time. And there’s a lot of confusion around it. I know there’s a lot of videos out there, let’s say on YouTube or podcast done describing it. I don’t know if they all do it justice. I don’t even know if I’m going to do it justice on this show, because I am certainly a why guy. So everything needs to go back to why. The idea of why even discuss what a MEC is, and why it acts as almost a curse word in infinite banking circles, and I don’t think it really needs to be that way.

So I’m hoping to paint a really solid picture of what it is. I know we’ve actually discussed a little bit of a MEC in previous podcasts episodes as well, so we’re going to go ahead and dive in. So for those of you who are pretty new to the idea of infinite banking, which is what we promote and what we love to talk about here in Dollars and Nonsense, the whole goal that we’re trying to communicate is that you can become your own banker through a specific type of life insurance policy, specifically dividend-paying whole life insurance policies issued by mutual companies. And so the infinite banking concept is all about paying large premiums, and by large is a relative term. I mean, for your situation, we’re trying to put in as much money as we possibly can into these policies, then use those policies like a banking system.

And I know it sounds kind of marketing, I’m just saying that’s what we’re doing. So we’re putting a lot of capital into policies relative to your situation, and then we’re pulling money out of those. We’re leveraging the cash values that are produced inside the policies to live life, to make investments, to go on vacation, to buy cars. I mean, anything that you do that needs money, we want to use essentially what we call your own bank, which is funded with through these policies. It’s the source of capital for all the things of life. So that is the concept in a very quick nutshell. What this means to you and me though, is that, obviously whenever you’re trying to build a policy to solve for the banking function in your life, you would want that policy to have as much cash value as it possibly can for every dollar that you deposit into it.

This is where the idea of the MEC even comes about. This is why it’s even worth talking about. This is why we bring it up. This is why it’s common to bring this up, because the IRS, the Internal Revenue Service, has essentially created a formula that insurance has to follow in order for them to call it life insurance. And life insurance, everybody really knows, or if you don’t know it, I’m just saying it’s just common knowledge in the world that life insurance policies have very favorable tax treatment. So life insurance policies will grow tax free essentially, and can be accessed tax free under the vast majority of circumstances. So you can take out a policy loan will always be a tax free distribution, and even withdrawals, the vast majority of the time, are going to be tax free up to your basis in the contract.

So this is not exactly going to dive in too deeply into what that means, but essentially everyone would like to have a life insurance policy with the tax advantages alongside with it. The problem was, especially back in the 1980s, there were people really taking advantage of the tax advantages of life insurance, which they should do. We should take advantage of every tax break that we possibly can. And so people were just doing what was called single premium life insurance policies. And what these were, was they were essentially just individuals dumping large premium dollars, multimillion dollars one time. And pretty much in a single premium policy, which by the way is a MEC, and we’re going to talk about that. Practically, every dollar or premium goes straight into cash value. It starts earning the guaranteed growth of the policy, and producing dividends right away on the full amount. And the death benefit was very small on these single premium policies.

So wealthy people would just dump millions of dollars into single premium whole life insurance policies, and live off the tax-free growth of the money. And the IRS got upset, and they came in. And they were essentially saying, guys, you guys are taking advantage of this. This doesn’t even look like life insurance anymore. This looks like an investment. And so they created this idea that we now call a modified endowment contract, where essentially it’s a new classification for a life insurance policy that does not pass the MEC test. And so now all single premium life insurance policies that were designed back then are now called the MEC. Now of course, if you owned one before the regulations came about, you were grandfathered in. But now if we were to build one under today’s circumstances, it would be called a modified endowment contract.

And a modified endowment contract essentially removes all of the real tax advantages or the main tax advantages from the life insurance policy itself. So it will look like a life insurance policy, it will act like a life insurance policy. You can use it like a life insurance policy, but you just don’t have the same tax favorable treatment of the policy whenever it’s classified as a modified endowment contract. And so we’re going to dive into today what exactly it is, how you can avoid it, what are the pros and cons of a MEC, and then of course in that, we’ll describe the situations that actually owning a MEC and forgoing the tax favorability of life insurance, can actually make sense for certain individuals whenever they want to practice the infinite banking concept.

So the MEC itself, the IRS essentially created a formula that all policies have to pass in order to be called life insurance policies. If they don’t pass this test, then it’s called a MEC. And the idea behind the formula is essentially the IRS says, the death benefit of your policy has to be large enough for whatever premium dollar you want to put in. If you want us to call this thing life insurance, and you want us to offer the favorable tax treatments that everyone can understand about life insurance, there has to be a satisfactory transfer of risk, which is the fundamental definition of insurance. The death benefit is the transfer of risk. The death benefit is the risk of dying early, and the life insurance is going to be paying on a death claim. They’re essentially saying the death benefit has to be large enough for whatever premium you want to pay.

So you can start a policy with any premium amount that you want to. You can start a small policy with a few $100 a month, and you can start a large policy with millions of dollars of premium going in every year. You can start any size policy you want, as far as how much you’re funding into the policy. But what will limit the design of the policy is going to be this idea of the MEC, which essentially says, if you want to put $10,000 a year into premium, the death benefit has to be at a certain level, and it’s a formula. The same thing would go if you wanted to put a $100,000 of premium in, the death benefit would have to be at a certain level above the premium. I wish I could say that the formula was just a simple like, hey, the death benefit has to be 10 times the premium at a minimum or something like that. Unfortunately, that’s not how it works.

The test that is used is technically called the 7-pay premium test, and I really don’t think it’s actually useful to go into what that even means or how that applies, because it really doesn’t matter. But what we can draw from the idea of this test is that depending on how old you are and where you’re at in the process, that the death benefit has to exceed a certain amount. And pretty much, you want the illustration software that you use to build policies to tell us what it is. Because it’s not just a simple little formula, it’s going to change and vary based on your age, gender, and health class. So all that to say, the MEC itself is saying there needs to be a legitimate transfer of risk by the insured to the insurance company in order for it to be called life insurance.

So that’s why the old style policies of single premium style policy where you could just… Let’s say somebody comes up to me with a $1 million in just cash. Back in the 1980s, early 1980s, they could legitimately just write one check for a $1 million, plop it down into what’s called a single premium life policy. All that million would essentially be available in cash value, 90 to 95% of it, and the death benefit would be relatively small comparatively. It would be maybe like one and a half to $2 million of death benefit, which is a relatively small amount of death benefit for the premium they just contributed.

But all that to say that’s what they could do before the 1980s, before the MEC concept was written into law. Then immediately that cash value would start growing and earning interest and dividends in the policy, and you could live on it tax free, that would’ve been great. The problem today is that now to be able to put in a million dollars, there needs to be a satisfactory transfer of risk involved. If you were to write one check for a $1 million, then the death benefit would have to be at a satisfactory level. The problem is carrying a large death benefit just to allow for a one-time high dumping of money, can be not practical. So we’re going to talk a bit about that too, and I know I’m opening a whole bunch of loose ends and not closing them, but I’m going to try to close them as we go on.

So essentially what you would have to do nowadays is make sure that the death benefit is large enough to allow for a million-dollar contribution. If you want to put in a $1 million, then you have to have a death benefit high enough to allow for that, which used to not be a thing, that’s essentially what a MEC is. And this is where you run into it. So what is a MEC? It is essentially a taxable version of a life insurance policy. So I’m going to describe a little bit of that. I’m going to describe how we avoid it. I’m going to describe the pros and cons of it, and then we’re going to end with what situations make sense. So as far as the tax consequences of a MEC, whenever you own a modified endowment contract, the IRS doesn’t tax it as life insurance. They see it as its own, almost like a deferred annuity of sorts, which I’m not going to go… That would be the technical tax classification.

But essentially what it’s going to do is, it still grows tax deferred. Which means, as it’s earning interest and as it’s earning dividends, you do not pay income tax as the money is earned, which is a bit different and it’s still slightly favorable that way if you would compare to let’s say, owning a bond portfolio that’s earning interest. Well, the interest is just taxable in the year that it’s paid. The same thing goes in like a CD at a bank or a savings account. Those types of things will pay interest, and it’s taxable the year it’s earned as interest income. Well, in a MEC, it still receives a tax treatment that’s slightly favorable, and that as it’s accumulating interest and dividends, those are built on a tax deferred basis. So you don’t pay tax as it’s being accrued, as it’s being earned. But the big difference is, you will pay tax when you start to access the funds inside of a modified endowment contract.

Let’s say you had put in a $1 million into a single premium policy, and it’s growing with interest and dividends. And a few years later, it’s $1.2 million of cash value, and you want to come take a policy loan or a simply withdrawal. All of the gains will be taxed in what’s called a last in, first out accounting structure. Which essentially to you and I, means, the million that you put in, you can actually get back tax free, but you can’t get at your principle until you have withdrawn all your interest and dividends. So that’s what last in, first out means. Which means all of the growth, all of the interest and dividends are withdrawn from the policy first, and then you can access your principle. The principle amount is still tax free because it was after-tax money that you put into the modified endowment contract, so it’s only the interest and dividends.

So let’s say you had a $1 million that you put in, it’s worth 1.2 million and you want to pull out 500,000. How that would be accounted for is 200,000 of it, the interest and dividends would be taxable as interest income that year. And then the $300,000 of your principle that you were withdrawing, of course you can get back without tax. But no matter what, you’re going to pay tax on the gains first. Which, if you compare that to a typical whole life policy the way we would normally design it, it’s done completely different. First off, a policy loan in a regular policy is never a taxable event. So you can always access 100% of the funds with no tax at any time, and you can withdraw your principle first before you withdraw any of the interest and dividends.

So you can take out your basis and actual withdrawals, and a regular life insurance policy that passes the MEC test, you can do it tax free. So that’s the main issue with the MEC is essentially the tax consequences that come about if you choose to go forward with this idea. And for the vast majority of clients, it would not make sense to own a MEC by the way. Because the tax consequences, as the account grows and grows and grows, and you start to receive more and more interest inside of it, the tax consequences, which is the con of a MEC, will not overcome the pro of owning a MEC. And so I thought I would also mention though, that it’s not all bad. That’s why I don’t like how the word MEC is used as a curse word in these circles when trying to build banks. Is that it’s not actually a curse word, it’s just a thing. It’s just a thing, and it has a set of pros and cons.

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Nate: For the vast majority of people, the cons greatly outweigh the pros of doing a MEC, but what is the pro of a MEC? Essentially, if you were going to design a perfect banking system like what we think we’ve done with dividend-paying whole life policies, designed the way we’re doing it. We’ve already brought up that you would want as much cash value as you possibly can get per dollar of premium. If you know anything about how these policies are designed, we understand that the death benefit of the policy and the cash value of the policy, oftentimes work contrary to each other. Where if you weigh one side of the equation, you normally get a reduction in the other side.

So what that means is if you wanted to get a big death benefit, if you want to buy a pulse with a large death benefit, let’s say you want to pass on a very large estate or you’re really concerned of taking care of your family if you die. Or your main concern is death benefit, and you build the policy accordingly, then that means that for every dollar of premium, you have a high death benefit, but your cash value will not be as efficient. As the reverse design could be, you come in and saying, I actually want cash value, and I want as much cash value as I possibly can. But in order to do that, you have to build a policy that, for the premium you’re putting in, the death benefit is relatively small or the cash value is as large as you can get it. So that’s what we’re dealing with.

Obviously, for infinite banking, for the people who work with Living Wealth and follow us, everybody’s on the cash value side. You don’t even have to tell us. Some clients I’ll talk to, they’ll say, I want to start a policy, I want to do this, and I really don’t care much about the death benefit. I really want to make sure it’s focused on cash value. I’m like, “That goes without saying when you’re practicing the infinite banking concept, that every policy design is going to maximize cash value and minimize death benefit.”

The reason why I’m bringing all of this up is to say a MEC will technically do that better than anything else. Because by definition, a MEC can be the lowest death benefit you possibly can and the maximum amount of cash value, especially in the short term. So the main pro of a MEC kind of comes in that form, in lieu of getting a huge set of tax advantages and having to fall prey to taxable distributions on all gains anytime you want to access. You get a policy with the very lowest death benefit as possible and the highest amount of cash value per dollar of premium, especially early on. It never outweighs the tax consequences in 99% of the people we would work with. The cons of paying tax on every dollar of gain every time you use it, always outweighs the lower death benefit, and in return, slightly higher cash values.

We want to avoid the MEC as much as possible. So the way you would build a normal policy for infinite banking, let’s say someone wants to put in a $100,000 of premium a year into a policy. What you would do is design that policy to where the death benefit is as low as you can get it and still allows for a $100,000 of premium. That’s what you would want it to do. So you’re getting the least amount of death benefit and the highest amount of cash value per dollar premium that you’re paying. And there’s a lot of different ways to do that. I’m not going to dive in too much into that. There are times though where a MEC can actually make sense. And that’s why I feel like it’s trampled down and pushed down so far, that there are occasionally times where a MEC will make sense to own. And I can think of two primary situations.

One of the situations, practically nobody listening to this podcast is going to care about. So I’m going to fly through that one. The second one though, I think every one of us will end up caring about or know people who would care about it. So the first situation where a MEC can actually make sense is if you happen to be affiliated with a nonprofit organization. So if you are a nonprofit, let’s say you are a pastor of a church, or really you raise money for a nonprofit organization that you love, or you lead one, or you’re on the board, or you work for one, just thought I’d let you know for that very small subset that’s listening to this podcast. A nonprofit can own policies on important people. Whether it’s donors, whether it’s board members, whether it’s executives in the nonprofit, whether it’s a pastor.

And so a nonprofit can, if they have capital, which we’ve had different churches and different nonprofits as clients of ours. Where they’ll have a lump sum of money, and they can actually own a MEC without experiencing tax consequences, because they’re a nonprofit. Which means they’re a tax-free entity, they don’t pay tax themselves. So they have $500,000 sitting in the bank waiting for a rainy day as a kind of a reserve fund for their operations. They could write a $500,000 check into a single premium modified endowment contract, and have all of the money practically hit cash value, operate with it, knowing that it’s technically a taxable policy, but once again, they’re a nonprofit, so that won’t apply to them.

I don’t know if that information’s going to be useful to you listeners too much, but you may attend a church, you may want to pitch them IBC, talk to the pastor or something like that, and it could wind its way down to it like, okay, yeah, for the church who can own a MEC without any consequences, it’d be great. But the second grouping is the one I actually want to spend some time on. The older you get, the more beneficial a modified endowment contract may become. There’s a few reasons for that. So if you start getting into your mid to late 70s, let’s say, the reason why a modified endowment contract or a single premium style policy may make sense is, there’s a few reasons for it, which we found in the past.

Number one, the amount of life left to live is obviously, you’re at the tail end of life, not to be morbid or anything of that sort. But we’re at the tail end of life as we’re in our mid to late 70s. Which means, under a normal circumstance it takes four, five, six, seven, eight, nine, 10 years depending on how the policy’s designed, and depending on how it can be designed, before a policy would even break even per se, as far as premiums paid in, to cash value that can be pulled out when you’re building it to avoid the MEC rules. And obviously the later you get in life, the less time you have to wait for the gains of the policy to make sense. And then there’s not actually a lot of time after that to live, in which case you would experience the tax-free gains inside of the policy.

And so what we find is a lot of people in that stage of life may have liquid money, just savings accounts or brokerage accounts, or various things, maybe they’ve sold a business. So they’re sitting on this money and they don’t really know what to do with it. To them, it very well could make sense to pursue a modified endowment contract, because the tax cons may actually at that time not outweigh the simplicity pro of a MEC, just having a one-time contribution, as well as the immediate availability of capital pro that you can gain instantaneously. So let me back up one more point I forgot to mention. That in order to pass the MEC test, you would oftentimes have to design your policy where you are going to fund it for a few years, you really can’t do what’s called the single premium policy.

If you are 50 years old, and you came to me with a $1 million after selling a piece of property or something like that, we oftentimes would move that money into a policy over a few years, maybe $350,000 over three years. Or 250,000 over four years. We would move it in over a period of time, because we really can’t get away with just doing a single premium for 1 million and have it not be classified as a MEC. And for a 50-year-old who might have 40 years left of life, the amount of gains in that policy is going to be astronomical. That would be a foolish decision. There is no way that the pro of being able to add it in all at once quickly is going to exceed the cons of the tax consequences of the MEC. There’s just no way it’s going to happen.

But if you are 75, 77, 78, then it can start to make sense where you could just take, let’s say as I was bringing up the person with $500,000. They can just write one check into a single premium policy, and immediately keep access to the vast majority of it. It would actually come with a death benefit. Let’s say maybe you write a check for 500, and you get insured right away for 800,000 a death benefit, something like that. So that would be maybe a 1 million, it kind of depends on age. And immediately the policy would be growing in a tax-deferred manner, and you would only pay taxes on the capital that’s accumulating if you were to use it. So what we find is that the older you get, the more it may make sense to own a MEC, because the timeframe for the compound interest to accrue in any asset, of course, policies included, has shrunk down the older you get.

So let’s say that if they lived for 10 years, the policy would’ve grown from 500 to $700,000 or something like that. That’s great. The 200,000 may have been taxable over that 10 years if they’d accessed it. But what I’m saying is the tax consequences may not actually outweigh the pros of being able to get it all in, have it all available in liquid cash, and be able to break even much sooner according to single premium policy. So number one, the policy itself is going to simplify things for that individual. They don’t have a huge time horizon for compound interest to occur no matter what they do, but you want to get as much of it as possible in the time you have left, which a MEC can obviously do that better than any other type of policy per se. And the con of having a taxable situation may not be as much of an issue at that time.

The other thing to note is that you’ll meet with a lot of people who they’re actually hoping at that age, they’re actually hoping that they never would even need to touch the money, that’s their hope. So it’s not that we would discourage you from practicing IBC in your upper 70s into the 80s, but I’m just saying that people we’ve talked to, they’re like, yeah, I would like to put money in here to keep it safe and accessible anytime I need it. But deep down, I kind of hope I don’t have to. If I have to start touching that, that would mean that I’m starting to dip into savings I was hoping not to touch. So you run into those people as well. Some of that may be your parents. For those of you listening to the show, where you have parents who are sitting on a lot of money, a lot of capital, they want to keep it safe.

They want to keep it growing competitively. They want to leave as much as possible to their next generation, and they’re not really even thinking they may need to use the money, but they’re kind of at a loss for where to put it. Once again, a MEC can start to fit the bill in their age, possibly even better than a typical policy that’s non-tax. For all of this to say, a MEC is what we all have to deal with it. 99% of the people we talk to, it would not make sense, it would be foolish to try to create a MEC. We don’t ever create MECs by default, unless you are a part of the population who would come talk to us. In which case, we may recommend a MEC. I don’t think it should be a curse word, it shouldn’t be something so to be avoided at all costs, under all circumstances, at all ages. I think that would be kind of foolish. It is actually a viable tool to fit certain specific people.

There’s a lot of benefits to it. Pretty much in every circumstance, the cons will outweigh it, unless you start to get upper in ages with a large pool of capital, you want to keep safe, secure, growing in a very competitive manner, and accessible at all times, a MEC will fit that bill. And it still produces far better results than any other sort of safe money you can get it. As far as on the you and me level, a MEC by its nature, is essentially a formula that’s been developed by the IRS that’s going to determine how much death benefit a policy needs to have in order to contribute whatever you want to contribute. So let’s say like a $10,000 premium if you wanted to start, would need to have, let’s say a $100,000 of death benefit.

Comparatively speaking, if you wanted to put a $100,000 of premium in, you would maybe per se need a $1 million of death benefit. In other words, the death benefit has to be at a sufficient level in order for the policy itself to be called life insurance by the IRS. That would mean that there’s some repercussions of that. The single premium policy of old can no longer be done by itself. It oftentimes would need to be split up over a few years, to dump in large contributions like that over time, without creating a MEC, is essentially how that would go for the vast majority of us.

I have gone even longer than I had wanted to go on this topic, so I’m going to have to shut it down. I may revisit it later. If anyone here has questions on a MEC, or possibly maybe you’re thinking of your parents or maybe you’re thinking of your church, or you’re thinking of some sort of other nonprofit organization that you would like to chat about this, or you think that’s a cool idea, just go ahead and ask me questions. Anybody here can email me, nate@livingwealth.com. I’d be happy to answer your questions on this, or for the people you’re thinking about. Are you just interested in learning more about how MEC applies to the infinite banking concept and to the policy design? I’d be happy to chat about that with you as well. But it’s been fun. I hope it was beneficial to you. I’m sure we’ll talk about it again, but this was at least a good intro discussion to what a MEC is, and which circumstances it would make sense to own one. This has been Dollars and Nonsense. If you follow the herd, you will be slaughtered.

Announcer: With that, we wrap up episode number 159 of Dollars and Nonsense. Get show notes, transcripts, and other resources by going to livingwealth.com/e159. Listeners, one last thing before you go. Start your journey towards financial security and wealth today. Visit livingwealth.com/beatinflation. You’ll gain instant free access to the beginner’s course, Ray, Nate, and Holly made just for you. Again, that’s livingwealth.com/beatinflation.