E108: Modified Endowment Contracts: What Are They and What You Need to Know About

In this episode, we answer common questions about modified endowment contracts (MEC). What is a MEC? How do they apply to infinite banking policies? Does it ever make sense to own a policy that is classified as a modified endowment contract?

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Then if you’ve been around the neighborhood of infinite banking, you’ve probably heard the term MEC or modified endowment contract. You might be wondering, what this means. In this episode, we deep dive and share all you need to know.

Modified Endowment Contracts Episode Resources:

  • What modified endowment contracts are exactly
  • What MEC has to do with Taxes
  • How they fit into your overall policy construction and strategies
  • Does the policy really grow tax-free
  • When a MEC must be created to do its job for you
  • When it makes sense to implement a Modified Endowment Contracts
  • When it makes sense to NOT implement a Modified Endowment Contracts

More Resources:

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Modified Endowment Contracts (MEC) episode transcript

Nate: In this episode, we answer common questions about modified endowment contracts. What are they? How do they apply to infinite banking policies? Does it ever make sense to own a policy that is classified as a modified endowment contract? She’s Holly and she helps people find financial freedom.

Holly: He’s Nate. He makes sense out of money. This is Dollars and Nonsense. If you follow the herd, you will be slaughtered.

Nate: All right. Well, welcome back to the podcast everyone. Today we’ll be talking about something that is actually pretty crucial to this whole concept of infinite banking. Then if you’ve been around the neighborhood of infinite banking, you’ve probably heard the term MEC or modified endowment contract. You might be wondering, what does this mean? I think a lot of people understand that it has something to do with taxes and how that applies to these policies. There’s a little bit of confusion about this whole modified endowment contract or MEC. So we’re going to deep dive and discuss what it is, how it applies to us, how it applies to the policy design, and also open up a discussion on when it might actually make sense to own one. So Holly, let’s try to, in simple terms, describe what a modified endowment contract really is.

Holly: In simple terms a modified endowment contract is when your life insurance policies, cumulative premiums basically become taxable. It’s now a taxable event that the IRS is going to now tax you on your growth in your actual policy per se, that the growth becomes bigger than what you’ve put in in the premiums and because of the way it was structured, you now get to pay taxes on it.

Nate: Yeah, it sounds fun. I think what you said is how it’s structured. Yeah.

Holly: Yeah.

Nate: So typically in a whole life insurance policy, the cash value grows tax-free and we can use it to tax-free or at least we can always take a loan against the policy and have it not be a taxable event. In a typical whole life insurance policy, you can also take a withdrawal of all of your premiums that you’ve put in to the policy. So it’s called your cost basis. So if you’ve put in $500,000 over your lifetime, you can take actual true withdrawals against the policy up to $500,000. Then if you want to withdraw past that, past your basis, it would be taxable, but most people never do that. Most people you can withdraw your basis, but then you start taking policy loans against the policy to avoid ever paying taxes on any of the growth of the policy.

Very powerful, but a modified endowment contract does not allow for that. A modified endowment contract is taxed completely differently. Anytime there’s a gain in it and you do a policy transaction like a loan or a withdrawal, if you own a MEC, that money that you just withdrew will be taxable. It’s called LIFO or last in first out. That’s the accounting term for saying the interest comes out of the policy first or the gains come out of the policy first and then you get your principal back. So all of the gains that you have inside your policy will be taxable on the transaction. So it’s commonly something we want to avoid getting. We want to avoid owning a modified endowment contract, but as Holly said, how it’s structured is really going to determine for most of us whether we own a MEC or not. So essentially it comes out in the beginning when we actually are building a policy. So Holly, you and I, when we’re building a policy, we understand that there’s this potential to create a MEC. My question is how do you create a MEC?

Holly: Well, there’s a few different ways. Often time, the most easiest way I’m going to say it, I’m just going to throw this out there, is when you just pay a single paid premium. You pay that premium one time and automatically it’s a MEC because you only put in that cash or that money one time and so it causes it to be a MEC. The other biggest thing we look at is because we’re using base premium and paid up additions rider is when that paid up additions rider is way higher than the base premium. So I’m going to use $10,000. When you put in $7,000 of cash and $3,000 of what we call base premium, nine times out of 10, it’s automatically going to be a MEC.

Nate: Yeah. So essentially you can create a MEC at the very beginning by how you design the policy. I mean, that’s really where it comes in. I think some people maybe are overly worried about it, Holly. Where they’re like treading on eggshells when they’re using their policies. What if I create a MEC. It’s very difficult to ever actually end up owning a MEC if it wasn’t created as a MEC. So essentially when we’re building out a policy, we want to produce for our clients as much cash value as we possibly can based on the premium they’re paying. So as Holly said, if you’re wanting to pay a $10,000 premium, we’re going to engineer the policy to produce as much cash value as possible of that $10,000 produces efficient of a policy as we can. We do that by essentially buying as little death benefit as we can and stuffing im as much cash value as we can.

The limiting factor there though is the modified endowment contract regulations that essentially the IRS has come in and they’ve said, “Well, we are not taxing life insurance policies, but you can actually create one that we’re not even going to call life insurance because the death benefit is so small compared to what you’re paying in in premium.” So that’s really where it boils down to. We have to buy just enough death benefit inside of a policy in order to pay the premium that we’re trying to pay. So that’s why Holly had mentioned the base premium is really what’s producing the vast majority of the death benefit and the paid-up additions rider in the early years is what’s producing the vast majority of the cash value. So it’s limiting how much we can pay into either one. So we would all like to stuff a hundred percent of our premium into cash value from day one.

The problem is that would be classified as a MEC because we would not have bought enough death benefit in a policy like that in order to have the IRS actually call it life insurance. The most basic thing I can do Holly, to describe it is just to say, whenever you’re building a policy, there’s kind of a ratio between how much base premium you have to pay and how much paid-up addition rider you can pay. Because of that, there’s going to be a limit. Like on a $10,000 policy, we can’t just put a dollar into base premium and $9,999 into paid-up addition rider. That’d be called a MEC. There’s got to be a decent ratio there for them to actually classify it as life insurance, but you want the MEC limit to be very close to what you’re paying in premium. That’s one way that you can know that the policy is maximized for cash value.

Holly: I think Nate made a really good point. When we are designing and structuring these policies for you, we are trying to make your money as efficient as possible, and trying to get as close to that MEC limit without creating a MEC on the cash value the paid up addition side, and as low of a base premium as we can get in order to make your money efficient for you from the very beginning.

Nate: Exactly. So that’s really where it comes into play is more at the initial design of it. I mean, it is true that as you continue on in the years to come and you’re paying premiums, that Modified Endowment Contracts limit does stick with you though. So that’s where I think some people get concerned is that maybe you’re starting a policy with a $10,000 premium total, base in PUA, and we design it to be maximized for cash value.

That would mean that the Modified Endowment Contracts limit might be like 11,000 in that policy. It’s going to be pretty close to the premium you’re paying, which means there’s a little bit of wiggle room to add some more money each year. Just not very much. So some people say, “Well, Nate, what if I add too much money in a later year?” Well, our suggestion to you is if you’re going to pay money into the policy that we didn’t plan on you paying in, which is always a good thing, we want you to put money into the policy as much as possible. What we always suggest you do is ask the insurance company or ask us, and we contact the insurance company and have them run a calculation where they’ll say, “Okay, here’s how much money can fit into this policy right now without crossing it into the MEC territory.”

We just suggest you do that before you add any additional premium that wasn’t scheduled. Let me also say Holly really quick that even if you didn’t do that and you’re just like, “I hope they can accept it,” and you just send the money in. What happens is that if you happened to send too much money in, it would have created a MEC, they always notify you and they notify us and they say, “We received this check. The policy can’t fit this in without becoming a MEC. We assume you don’t want this. So we’re going to send the overage back.” So it’s not something that can just sneak up on you and then you accidentally have a MEC. Even if you didn’t correct it, they will even go back years before and reverse transactions to keep your policy from becoming a MEC. So they know you don’t want one. It’s practically impossible to accidentally have one. You either have one from the very beginning or you don’t. There’s really not much in between. It’s not something you have to be worried about.

Holly: Yeah. I can speak directly to this Nate. I had a client who sent them 34 cents more than what could be put into the policy. They sent her a letter saying, what do you want us to do with this 34 cents? Do you want us to mail you a check back? Do you want us to add it to your outstanding loan balance and reduce it by 34 cents? What do you want us to do to prevent this from being a MEC? So even if it’s just a couple cents over, or it’s a couple thousand dollars over, they’re trying to give you options to be able to prevent it from becoming a Modified Endowment Contract.

Nate: Yeah. I’ve had a few clients here as well Holly that sent them too much money and they had to send money back and it’s not even a worrisome thing. So that’s one thing I wanted to mention this episode. I think some people make it to be too big of a deal. The MEC essentially, we design a policy and it’s not a MEC. You’re going to have to really kick and scream your way into creating one in the future. You’re going to pretty much have to decide I’m going to send the money and I know it’s going to be a MEC because I want a MEC. That’s essentially what you’re going to have to do to get to have one. I mean, it’s impossible to accidentally trigger one because there’s just no way that they will not reverse transactions for you or send you back money, even if it’s been years since it occurred.

So it’s just not something that you need to worry about. What we wanted to mention is that when it comes up is when we’re building the policy, there’s limits to how we can build it. We’re building policies that are best for the clients, which is essentially maximizing cash value as much as we can without crossing into the MEC or modified endowment contract territory. That’s how you know your policy is geared for cash value, which is what you want for infinite banking purposes. It’s going to produce the most money and profit for you. In turn, you’re essentially buying a policy with as little death benefit as you possibly can and as much cash value as you possibly can. It mainly comes down to a ratio of your premiums. How much base premium can you pay and how much paid-up addition rider can you pay without crossing into the modified endowments contract limit territory?

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Nate: Any other points you want to make before we kind of switch over gears and talk about when it actually might make sense to own one?

Holly: No, I think we should go into, why would you ever want to own a MEC?

Nate: There are a few instances where it might actually make sense to own a MEC. The most common one that we’ve ran into is as most of us know, nonprofits do not pay taxes. So it doesn’t matter actually where they’re saving money. If they put it into a savings account and the savings account earned some interest or a CD account earned some interest, a non-profit doesn’t owe income taxes. So there’s no tax liability to be found whenever they receive profit from where they’re holding their funds. We’ve actually worked plenty times with churches in this world where a church has some extra money that they’ve saved, kind of a contingency fund or something like that. Currently just sitting in cash, doing practically nothing. They hear about this concept, or maybe their pastor hears about this concept and think, “Well, maybe this is a good place for some money to go.”

Well, since the church has some money and does not actually owe taxes on any profit it makes, they can go out and buy a MEC or they could even do it what Holly said we can’t do. Essentially, which is pay what’s called a single premium policy. If they had $50,000 saved up in a contingency fund or a building fund, they could write one check for $50,000 and move it all into a policy day one, have pretty little death benefit, but have practically all of it go straight into cash value. Essentially just one big paid-up additions. So we’ve seen plenty of churches own MECs because it doesn’t matter if it’s taxable income because they don’t actually pay taxes on the growth of a MEC.

Holly: I think it’s a brilliant way for nonprofits and churches to actually use a different vehicle other than a traditional bank or a CD or a savings for what they’re planning on doing and actually gives them an avenue that they actually can access their cash now. Even in death have a death benefit that does pass to the church to do it all over again.

Nate: Exactly. I know my church is doing this right now with their pastor. They had some money saved. They actually had a death of a member of the church who had left some money in their estate for the church and they didn’t need the money. So they thought they would put it inside and wait to see when they would need it or wanted to use it to accomplish something. Due to some influence from me and the pastor who’s a client of mine, we ended up starting a policy on the pastor. The church owns a policy on the pastor and the church will use this policy as its cash reserves. We see that happen all the time. As you mentioned Holly, there’s a side benefit. Even though a MEC doesn’t have a ton of death benefit, it does have death benefit. So at some point, the pastor will pass away and the church will be flushed with cash from the death benefit, which is higher than the cash value.

Holly: I think that’s one of the keys is understanding that just because a policy is a Modified Endowment Contract doesn’t mean the death benefit that passes is a MEC. It’s not taxable to the beneficiary.

Nate: That is a good point that we forgot to mention. You’re right. That while using the cash value can trigger a taxable event if you own a Modified Endowment Contract, the death benefit still passes down to the next generation tax-free. So that kind of leads us Holly into the other small subset of people who might want to own Modified Endowment Contracts. If you are an individual and listening to this podcast and you’re in your seventies, or you have parents who are older individuals and they’ve got a whole bunch of cash. They don’t want to be in the stock market. They’re not earning anything in a CD or savings, but they want to put their money to work some place, but they don’t really want to build out a policy where they have to pay premiums for years to come for five, six, seven, eight, nine years or whatever it is.

They just want to move it in all at once. It can make sense for those individuals to just do what’s called a single premium policy where you’ll write a check for a hundred thousand, 200,000, 500,000, something like that. You own a Modified Endowment Contract, but the vast majority of that, like 95% of it is available in cash value right away. It still does produce a death benefit and the money actually grows what’s called tax deferred inside of a MEC. So in other words, as you’re receiving dividends and cash value increase, you don’t actually owe taxes on it the year it accrues. So if you have a CD or a savings account that earns interest, you have to pay taxes on it every year that it earns interest whether or not you need it or not. The nice thing about a Modified Endowment Contract is that it does grow tax deferred.

So you don’t actually need to pay any tax on it until you use it. If you’re saying, “Well, this is money I may or may not need to use,” it can be a good place to hold it. Even if you would have to pay taxes on the gains, because you would’ve had to pay taxes on the gains in your savings account or CD anyway. At the end of the day, whenever that person passes away, the death benefit, which is going to be greater than the cash value was in the first place by a decent margin is going to pass to the next generation tax-free. So they’re actually for older individuals, I’ve seen it make some sense more so than if you’re 50 years old and you’re going to live until age 85, and you’re going to make a lot of money in this policy it would make sense to not just do a Modified Endowment Contract.

If you’re 75 and planning on living to 85, 90, 95, and there’s a shorter amount of time, it could make sense. I’m not making a blanket statement there, but it could make sense. I’ve seen it make sense in the past.

Holly: The reality is if you are older and you just have it in a savings account, or like Nate said, a CD in your bank, putting it into a life insurance policy, you still pay taxes if you use it. That’s the key, if you use it, right? If you’re not using it, it’s just your emergency fund or that, I’m going to say you’re going to get more bang for your buck if you want to put it that way.

Nate: By a long shot. Yeah.

Holly: Yeah because there is a death benefit. What it allows you to do as an older individual is it enables you a possibility to leave a larger tax-free amount to your children or heirs or whoever you want to leave that money to with really no out-of-pocket costs. Except for if you use that money while you’re alive. For a lot of us out there, we’ve just been told to park our money in a bank and leave it. Then in reality, we never really use it because we’re afraid we’re going to run out of money anyways.

Nate: Yeah, yeah. Essentially, when we’re talking about infinite banking, all we’re really trying to teach people to do is using a mutual life insurance company’s dividend paying whole life policy, it’s just a better place for money to flow to and from. We do believe that a MEC is typically not a better thing to own, a non-MEC because taxes are the greatest eroder of wealth. We want as much tax-free growth as we can possibly get over our lifetime. However, there can be times where even a MEC is a better decision to own. If you’re not a fit for those circumstances, then it would normally make sense to take your lump sum of money and pay premiums in over a few years timeframe to build up a policy that’s not a MEC and use it accordingly because the tax-free growth of it is going to end up producing more return for you than having to wait a few years to move all the money in. If you’re an older individual, it actually might make sense to do so. Anything else you can think of Holly?

Holly: I think we’ve done a really good job.

Nate: All right.

Holly: I hope you guys understand really what Modified Endowment Contracts are and really that sometimes it might make sense to own a Modified Endowment Contract, but even the sometimes is very specific individual or a very specific case.

Nate: Yeah, exactly. So if you are listening to this, you’re a little bit older. It’s possible that you might qualify as a person who would make sense to own a MEC, or maybe if you have parents that you know have a lot of money sitting in cash, really just not doing anything, they would be a decent candidate to potentially own a modified endowment contract. For the most part, we try to build policies that do not end up being Modified Endowment Contracts so that we can receive tax-free growth and use it tax-free. I hope that you found this episode beneficial. This has been Dollars and Nonsense. If you follow the herd, you will get slaughtered.

Holly: For free transcripts and resources, please visit livingwealth.com/e108.

Announcer: Dollars and Nonsense podcast listeners, one more thing before you go. Ease your worry and start your journey towards security today. Visit livingwealth.com/secretbanking. You’ll gain instant free access to the special one hour course Holly and Nate made. Again, that’s livingwealth.com/secretbanking.