A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hello there, David McKnight. Welcome to The Power of Zero show. Grateful you're on this journey with me week after week, coming to you every Wednesday like clockwork. The bestselling author of The Power of Zero, Look Before You LIRP, and most recently, The Volatility Shield, I’ve been getting a lot of great feedback from you, guys, appreciate the notes I've been getting from you guys on The Volatility Shield. Loved writing that book and I loved how it turned out. Of course, you can buy all of those onesies and twosies on Amazon or if you want to buy them in bulk, just go to powerofzero.com/Books and you can get them in bulk discount. Don't forget about The Power of Zero: The Tax Train Is Coming movie. That can be streamed on any of the major streaming services, whether it be Google, YouTube, Amazon, iTunes, reelhouse.org, what have you.
Today we are going to talk about a grab bag of things that have to do with life insurance. We're going to talk about something called a modified endowment contract, some scenarios in which life insurance can be taxed, and then something called a tax-free 1035 exchange.
Now let's start off talking about what's called an MEC or a modified endowment contract. First of all, the IRS has a test, it's called a seven-pay test—and I'm not going to get too into the weeds on this—but the seven-pay test basically says, “In the first seven years, you can put too much money into a life insurance policy and if you violate what's called the seven-pay premium test, then any withdrawals or loans that you take from your life insurance policy get treated differently, they get treated more or less like a non-qualified annuity.”
Before we get too far into this, let's talk about how it works with a life insurance policy if you don't violate the seven-pay premium test. Traditionally, what happens is if you can obey all of the rules with the IRS, you put money in after-tax into a life insurance policy, grows tax-deferred, if you take it out the right way, you can take it out tax-free. When I say you take it out tax-free, I say that you take it out by way of a loan. Now you're not required to take it out by way of a loan, let's talk about what happens if you don't take the money out by way of a loan.
The other alternative that you have is that you can take money out of a non-MEC life insurance policy by way of a policy withdrawal. The way that works is it's first-in, first-out, a non-MEC contract is first-in, first-out. What does that mean? That means whatever basis or whatever principle you hold in the contract—which are basically your contributions—you can take that out tax-free, no taxable implications. Anything above and beyond your basis, which would be your growth, you can take out but you would pay ordinary income tax on that if you did it by way of withdrawal.
We generally encourage you not to take the money out by way of a withdrawal because if you do it that way, it's not going to be tax-free, the taxation is going to feel a little bit like a 401(k), IRA, what have you, that growth portion of the distribution is going to show up on your tax return, your 1099 Form. That's why if we're going to take distributions out of a life insurance policy, we can withdraw up to basis, and then anything above and beyond the basis, we can take out by way of a loan. We're basically using our life insurance policy as collateral for a loan that we take from the life insurance company itself.
If you are using a policy that allows you to take out variable loans or participating loans, then you're probably going to want to take the loan out on everything. You don't want to withdraw the basis, you want to take a loan on the basis, you want to take a loan on everything because that 1% or 2% arbitrage that you experienced on the principle and on the growth is going to give you a much larger distribution, a much larger stream of income over time. That's how we might deal with a traditional well-funded non-MEC contract; you withdraw up to basis, you loan anything above and beyond. If you choose, for whatever reason, to take a withdrawal, you're going to have to pay ordinary income tax on anything above and beyond your basis.
Now, let's shift here, let's talk about what happens if you do violate that seven-pay test and you have what's called a modified endowment contract. Modify endowment contracts are not the end of the world. A lot of people do modified endowment contracts on purpose, they will contribute a huge lump sum of money to the life insurance policy. The death benefit is always going to be tax-free whether it's MEC or non-MEC, it's always going to go tax-free to the heirs. A lot of people like to put a lump sum into a life insurance policy because the rate of return they get on that; they can get liquidity, some companies allow you to waive surrenders, if you're growing money safely and productively, it's certainly going to beat whatever you're getting in a CD, but you have to understand what the taxation is going to be when you take the money out.
When it's a MEC and you want to take money out, all of a sudden, you flip from first-in, first-out to last-in, first-out. What that means is that whether you're taking a loan or a withdrawal, it doesn't matter, from a modified endowment contract, you are going to pay taxation on a last-in, first-out basis, which means you're going to pay tax on any of the growth first. The principal will always be returned to you tax-free because you use after-tax dollars to put the money in the first place, but any growth that you take out by way of a loan or withdrawal is going to be taxed on a last-in, first-out basis. You're going to pay tax on that before you get to the good stuff which is the tax-free return of your basis. That's a pretty big deal and it's an even bigger deal if you're younger than 59 1/2 because if you're younger than 59 1/2, you're also going to pay a 10% penalty on any of that loan or withdrawal that's on the growth in that policy.
There could be some serious repercussions if you're putting too much money into these policies and you're thinking that you can take money out like you would a normal non-MEC contract. You got to be very, very careful if you do a MEC, if you're using it like a lot of people use it, which is to get a big lump sum in there and if you end up not needing it and ends up going tax-free to the heirs, but if you need it in the meantime, you know you're going to pay tax only on the growth on a last-in, first-out basis, just recognize if you're younger than 59 1/2, you will have a 10% penalty and will end up being one of the worst investments you ever made because you got an immediate 10% reduction on any of those distributions. That's the difference in taxation on a non-MEC, which is the preferable way to go, versus a MEC contract.
Now I see some advisors out there say that they love MECs, I think that in certain situations, MECs are great. If you want to get a whole lot of money in very early on in the contract, take advantage of time, value of money because all of your money is in there from the very beginning as opposed to streaming it in overtime, then it may be a good strategy when coupled with everything else that you're doing, you just have to recognize that one of the big tenants of The Power of Zero paradigm is that we want to have the right amounts of money in the right types of accounts in a rising tax-rate environment. If you have huge amounts of taxes that you're paying on withdrawals from these MEC contracts, you are exposing yourself to some extent to tax-rate risk, so you got to recognize that and you've got to be cognizant of it.
Let's talk about a 1035 exchange. Let's say you have a life insurance policy, it's old, antiquated, it doesn't have all the bells and whistles that the new policies have, and you're still in good health and you want to exchange that policy for one of the newfangled ones that has maybe some more efficiencies, and maybe it has a chronic illness writer that your old policy didn't have, maybe you were originally participating in a universal life contract which only allowed you to have returns that were linked to interest rates or returns linked to the general portfolio of the life insurance company, say, “Hey, look, I want to take advantage of a variable universal life policy or even an indexed universal life policy, I want to get higher rates of return,” you can do what's called a 1035 exchange. When you do a 1035 exchange, it's tax-free. You can take all of the cash value from that existing policy and you can roll it tax-free into the new policy.
A couple of bugaboos here, a couple of things you got to watch out for, first of all, once a modified endowment contract, once a MEC, always a MEC, so if you do a 1035 exchange on a modified endowment contract, the new contract into which you're rolling the policy is likewise going to be a modified endowment contract. If you have a non-MEC policy, you roll that into another non-MEC policy, no problem at all. But if you have a MEC policy and you try to roll that into a new policy, the new policy is likewise going to be a MEC with all of the same tax ramifications that we talked about earlier.
There's another thing that you can do with a 1035 exchange that you need to be aware of, if you have a non-MEC life insurance policy, you can roll that into an annuity. Of course, once it's in the annuity, you're going to lose any ability to take money out of it tax-free. You absolutely need an escape hatch somewhere down the road for your life insurance policy because, at some point in time, you're not going to want to pay for the mortality expenses associated with that policy, you can roll that policy into an annuity.
Let's examine the flip side, the flip side is this; can you roll an annuity into a life insurance policy? The answer is no, that’s a one-way street. You can only roll life insurance policies into annuities, you cannot roll annuities into life insurance. Really, what I wanted to talk about today is I want to talk about the difference between a MEC and a non-MEC and what are the rules of taxation vis-a-vis both of those contracts, there can be some extensive and far-reaching implications when you do this the wrong way.
I want to talk a little bit about 1035 exchanges. There are escape hatches in these policies, you're not necessarily confined to these policies for life, you can shift out of the policy or you can shift into a new policy, but you have to remember that once a MEC, always a MEC and when you switch from life insurance policy to an annuity, it's a one-way street, you can't do it the reverse way.
If you find yourself in a position where you need some help navigating the path to 0% tax bracket and you don't know who to turn to, absolutely reach out to us, you can do so at davidmcknight.com. We're happy to help you with that and answer any questions that you have along the way. There are massive potholes and roadblocks standing between you in the 0% tax bracket. If you don't want to navigate that path alone, we are happy to help shepherd you through that process.
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