Beware of Life Insurance Being Marketed as Annuity Death Tax Protection

An advertisement for insurance agents showed up in my email the other day touting a way to help people avoid the "Annuity Death Tax."  It promises agents a 15% commission on the initial premium aid with the application.

ut what this ad was promoting was selling folks a "Modified Endowment Contract" ("MEC") -- nothing related to an annuity at all.    A person under age 59-1/2 would NEVER want a life insurance contract such as this.  And, truth be told, most folks over age 59-1/2 don't want this either.  So what's it all about?

An annuity has cash value, like a whole life or universal life insurance policy.  Most annuities are "nonqualified" contracts -- which simply means you don't get a tax deduction for the money you pay into the contract.  When you eventually take that money out, you won't pay tax on it again.  But any interest you earn along the way will be taxable as income when you take it out.  And if you just want to take some of the money out for your own use, the IRS makes you take the taxable interest out before you take out the tax-free portion.  If you touch the money before you are age 59-1./2, then, like touching retirement account money, you will also be hit with a 10% penalty tax. 

Annuities have a "death benefit" for a beneficiary if the contract has not been converted into the payout phase (called "annuitization").  It is the greater of the contract value or the original funding amount (less any withdrawals).  But the interest portion of the payment is a taxable event for the beneficiary.  Depending on the amount of interest accumulated, it could amount to several thousand dollars in income tax due.  That's what's being referred to as the "Annuity Death Tax" -- nothing more than the income tax that is payable if the annuitant dies before annuitizing the contract.

ell, life insurance is also paid for with after-tax money.  But the death benefit is paid to your beneficiary free of any income tax.  The IRS knows your beneficiary will save, invest, or spend that money, and it will eventually generate income and other tax revenue.  You can also "borrow" money from the insurance company, using your life insurance cash value as collateral for the loan.  You either pay the money (plus interest) back to the insurance company, or they take it from the death benefit before the beneficiary is paid.

n the 1980s, when President Reagan and Congress "reformed" our Internal Revenue Code to "simplify" it, they also created an entirely new "thing" called a "Modified Endowment Contract."  A MEC was not something you could get from an insurance company.  But it was what your life insurance policy could become if you paid too much money into it in the early years, and would cause it to reach its maturity prior to your age 95. 

When a life insurance policy becomes a MEC, it loses its "definition" of life insurance in the Internal Revenue Code.  And it suddenly looks a lot like an annuity or a retirement account.  Everything except the death benefit paid to the beneficiary.  That is still paid income tax free.  Any other touching of the money by the policyowner results in a taxable event (and a 10% penalty tax if the policyowner is under age 59-1/2). 

niversal life insurance policies are the most likely candidates to become MECs.  But actual endowment policies (which usually reach maturity at age 65 or 70 or 75) are automatically considered MECs (an unintended consequence of the law).  So, too, are some single premium life insurance policies.  And that's what this "Annuity Death Tax" business is all about.

You might have a retirement account that has built up to several hundred thousand dollars, perhaps even a million dollars or more.  But you are worried that the stock market, that once reduced your savings by 40% or more just a few years ago, could do that same thing again, and it makes you nervous to think about it.  You could put that money in an annuity (even a variable annuity, but they are very high cost products) and guarantee that the value for the beneficiary would never decline on its own.

You don't take any medical exams, you could even be dying, and you can purchase an annuity as long as you have the money.  The longer it stays in the annuity, the more it will grow -- but not necessarily very fast.  Most annuities with interest rate guarantees only guarantee about 3% annual interest.  Not very much, but still better than you can get at the bank today. 

ou can take money out of your annuity, but some or all of your withdrawal (called a "partial surrender") could be subject to a surrender charge.  And most or all of the money you take out could be taxable as income because of the Internal Revenue Code. 

single-premium MEC life insurance policy looks almost exactly like an annuity.  Except that it would have a somewhat higher death benefit (the ad said up to 50% higher).  But unlike non-MEC life insurance, you have lost the right to take a loan against the policy, any partial surrender is a fully taxable event, until all the interest has been paid out.   The product being advertised is not something I would recommend to very many people, if any.  Once a policy becomes a MEC, it's a done deal.  It cannot be changed . . . . ever -- unless you can get the IRS to agree that you did not intentionally cause that to happen.  These policies being advertised are intentionally MECd, so forget about asking the IRS for a do-over. 

ut when a person drops $1,000,000 into one of these policies . . .  the agent pockets a cool $150,000 commission.  The beneficiary could be in line for a $1,500,000 payout.  But the policyowner, if they needed some cash for an emergency, would be heavily penalized by the insurance company and the IRS.  And that's where I think these products, if they become widely promoted, will get people into trouble. 

see this as the tip of the iceberg in future insurance litigation.  People will be misled by inexperienced agents who are mostly concerned about their own incomes, not that of their clients.  There is much potential for misrepresentation and/or concealment on the part of agents in the marketing of these policies.  And much of it could be centered on taxation issues the agents do not understand.  

This sales tactic has great potential to become a scam on consumers.  f someone tries to market such a product to you . . . please contact me before you sign any applications.  I will provide you with a complete analysis of the proposal at no cost whatsoever.  I don't want to have to represent you as an expert witness, if I can prevent it in the first place.