Modified Endowment Contract - A Brief Overview
A modified endowment contract is basically a money value life insurance contract within the United States in which the payouts have exceeded the predetermined amount allowed for the end-of-life benefits, usually reaching beyond the lifetime of the policyholder. The term "Modified Endowment Contract" has come to be used often in investment circles as an alternative to whole life policies. A modified endowment contract allows you to borrow cash for your death benefits, but then the payouts exceed the cash value of the death benefit, which is often considered a carryover basis. If a policyholder's death benefit is higher than their estate and personal assets allow, the payouts can exceed the estate and personal assets without tax implications, since the payouts are treated as regular income under the terms of the modified endowment contract.
The first modified endowment contract was put into place in 1950, with an amendment known as Meccano's Amendment. According to this amendment, an insurance company could not contractually obligate a policyholder to sell or give away any property to a third party, except that if the third party was a bank. The original wording of the amendment stated that it only applied to insurance companies, and not to investment companies.
The second modified endowment contract amendment made it expressly clear that the obligation of the insurance company did not extend to third parties, except to a bank. These modified endowment contracts are often used by investors to obtain cash proceeds from life insurance policies that have reached their face value, even though these policies have not yet expired. Insurance policies that are two to three years old may still be in force, even though the face values have dropped. By purchasing these policies from the insurance company, and paying the additional premiums required, the investor can receive a lump sum amount on the death of the policyholder, to use as they see fit. Most insurance policies that have a death benefit are usually "modified" plans that are intended to provide additional income to the beneficiary or beneficiaries once the policy has reached an end state.
As with all life insurance policies, however, there is always the possibility that the insurance company will not settle the claim or will not settle at all. In that case, the modified endowment contract provides that the beneficiary may choose to utilize the lump sum received to fulfill the remainder of the policy holder's financial obligations to his/her heirs. Some people utilize the modified endowment contract, or a modified whole life insurance policy, to build a trust. A beneficiary may use the lump sum to fulfill any obligation to provide regular financial support to the estate, or may use the money to purchase a house or other real estate property. In some cases, people also use the money to supplement the retirement income provided by a whole life policy, or to make an investment with which to build a fortune and no longer be tax-free.
Because of the flexibility of whole life insurance policies and the lack of federal regulation regarding modified endowment contracts, it is possible that a beneficiary could violate the terms of the contract by not fulfilling a need that is legally enforceable. This can result in the enforcement of liens against property or income tax claims. For that reason, it is important that any beneficiary take care to follow the terms of the modified endowment contract, including any applicable liens. The consequences of ignoring the contract could be very severe. If the Internal Revenue Service ever takes action against you or your beneficiary for non-compliance of the terms of the modified endowment contract, you may even lose your home and other assets and incur professional fees and legal costs to the tune of thousands of dollars.
Some people, although not concerned with the death benefit, use the modified endowment contract as a safety mechanism, thereby eliminating the risk that their investment will experience taxes in the future. One example is if the estate is exempt from Federal tax law. The modified endowment contract could pay the death benefit without requiring the annuitant to pay tax on the amounts deferred. However, in such cases, you should review the terms of the contract and make sure that you are not violating any regulations or laws. You may have to pay taxes on the deferred amount during the grace period. Visit here to schedule consultation.
Other related info can be found at https://www.britannica.com/topic/life-insurance .
Modified Endowment Contract - A Brief Overview