The IRS has a test called the seven pay premium test. It basically states that it’s possible to put too much money into a life insurance policy. If you fail that test than any loans that you take from your life insurance policy get treated differently.
Traditionally, if you obey the rules of the IRS you put money into a life insurance policy after tax and if you take the money out the right way you can do it tax free, typically by way of a loan.
The alternative is to take the money out of a non-MEC life insurance policy with a policy withdrawal. This happens on a first-in, first-out basis, which essentially means that you can take out the money in your basis tax-free, but anything from the growth portion of your account will be subject to ordinary income taxes.
Anything above the basis, you would take out in the form of a loan from the insurance company itself. However, there are some policies that allow you to take out variable or participatory loans against the whole amount.
Many people do Modified Endowment Contracts on purpose. In either case, the money will go to the heirs tax-free. The big difference is the order of the withdrawal structure. With an MEC policy, the order is last-in, first-out which means you will pay tax on the growth first before getting to your tax-free basis.
If you’re younger than 59 and a half, you will also pay a 10% penalty on any loan or withdrawal from a MEC policy. This can have major implications if you end up using the contract the way that most people do, as it can end up being the worst investment you will ever make.
The advantage to a MEC policy is that you can get a large lump sum into the policy early on and take advantage of the time value of money. You just have to recognize that you want to have the right amounts of money in the right accounts in a rising tax rate environment.
If you want to change your existing life insurance policy you can do a 1035 exchange and roll that money tax free into a new policy, but there are some things to watch out for. Once a MEC, always a MEC.
There is another thing you can do with a 1035 exchange where you can take the money in a non-MEC life insurance policy and roll that into an annuity. Once it’s an annuity, you will lose any ability to take money out tax-free, but the option is there if you need an escape hatch from your current life insurance policy.
The shift only goes one way, you can’t take an annuity and roll it into a life insurance policy.