Safe Investment with Higher Interest, No Downside Risk, Tax Benefits, and Liquidity
This unique low risk investment uses a special type of insurance contract to grow wealth conservatively and consistently while getting a whole host of extra benefits in the process.
In the late 1970s, many investors took advantage of overfunding life insurance policies to create tax shelters. They would put a large amount of money into single-premium life insurance and then withdraw all the principal and interest. In doing so, they never had to pay taxes on any of the gains.
In 1988, Congress passed a piece of legislation that designated overfunded life insurance policies as Modified Endowment Contracts (MECs). When you withdraw money from a MEC, the interest gains are withdrawn first, and you’ll pay ordinary income tax on those gains.
Ever since that change took place, most financial experts have told their clients to avoid having their insurance policies become MECs because of this tax treatment. In fact, if you search the term online, you will find a wide array of warnings related to MECs.
However, some MECs still work very well for smart investors.
The idea is to view MECs not as insurance policies, but rather as tax-efficient alternatives to CDs, money markets, or other “conservative” savings vehicles.
Why would this make sense? Let me walk you through an example that highlights everything step-by-step …
Say you have $100,000 in a taxable savings account or CD right now. This is money you don’t really plan on needing right now, but you like the idea of having it available just in case. If you keep it in a money market, you are probably earning less than 2% a year. If you choose a 1-year CD, you might get 2% but you will also have an early withdrawal penalty. Whether you use money market or CDs, you will owe tax each year on the minimal interest you earn. If you move into some type of Bond (Treasury, Municipals, etc.), you start to get into more risks — including interest rate risks and even default risks.
Now, what if you take that same $100,000 and put it into a well-designed MEC?
You will have an instant tax-free death benefit, because you are still buying a life insurance contract. That means if you die right after funding the contract, your heirs would get more than the $100,000 back tax-free. Depending on your age, maybe $200,000 or more. Moreover, the money will grow on a tax-deferred basis as if it is parked inside a tax-sheltered account like an IRA or 401(k). Most importantly, you can get the money back at any point if you need or want it.
If the gains are withdrawn before the owner is 59 ½, there’s an extra 10% tax on the gains, just as if you withdrew money from an IRA or 401(k). There are also NO required minimum distributions (RMDs) … ever!
What do the potential returns look like?
The 2 popular interest earning methods are based on the annual upside performance of the S&P 500 index:
- Interest credit of the percent gained by the S&P 500 index from the beginning of the policy year to the end of the policy year. If the index went down there’s a 0% floor, so regardless how much the index goes down, you won’t lose. There is a ‘Cap’ which is the most you will earn in a given year, even if the index performs better than the cap. Current cap is 9%.
- Interest credit of the percent gained by the S&P 500 index from the beginning of the policy year to the end of the policy year. If the index went down there’s a 0% floor, so regardless how much the index goes down, you won’t lose. There is no ‘Cap Rate’ to limit your annual earning potential. However, there is a ‘Spread’, which is a specified percent subtracted from the annual gain percentage. Current ‘Spread’ is 5.75%. So on a year the index is up 30%, you would get 24.25%.
Here’s an example: You started the MEC with the S&P 500 index at 2500 points and it goes down to 2000 points (20% loss) in year 1, and recovers back to 2500 (25% gain) in the 2nd year. You would not have lost anything in year 1 because you have a 0% floor. However, in year 2, you would have earned excellent interest. Either 9% using the ‘Cap’, or 19.25% with the ‘Spread’.
If you actually owned the index you would have only broken even! When you wipe away the down years, you have excellent upside potential using a MEC, sometimes better than the actual index itself!
What do these interest methods average annually?
Last 5 years: ‘Cap’ averaged 7.2% a year, and the ’Spread’ 9.2% a year.
Last 30 years: ‘Cap’ averaged 6.1% a year, and the ‘Spread’ 8.4% a year.
You have the right to switch between the different interest earning methods at the beginning of each policy year. This will determine how much interest you’ll earn at the end of the year. This flexibility is a nice feature for someone looking to introduce an element of market timing. You might want to choose the cap method for a year that you think the market won’t go up that much, or the spread method in a year you speculate a big increase in the market.
The insurance companies can change the credit methods at the end of each policy year. They can raise the cap rate to 15% or lower the cap to 8%. They can lower the ‘Spread’ to 3% or increase the spread to 7%. Historically, cap rates have been higher in times of higher interest rates and lower in times of low interest rates. The current 9% cap is the lowest we have ever seen in the current low-interest environment.
In offering these policies, most insurance companies charge upfront sales loads and surrender fees. But a few DON’T have these fees, and this is where the real game changer is.
A few companies have realized that these MECs are so attractive and investors rarely want to withdraw their money. Therefore, they don’t need to charge you a large load fee to force you to keep your money in.
You have the annual expenses that cover the benefits provided by the contracts. These fees typically run between 1% to 1.5% a year, and depend on the policy insured’s age, health and other factors. Costs can be modified by the insurance companies. The trend has actually been lower costs as people tend to live longer than they used to. You would also get advanced notice and have the right to simply withdraw your money if you didn’t like the new fees.
When you look at the average annual interest after fees that you might expect to earn based on the past 30 years.
Approximately 5% in the S&P 500 index ‘Cap’ method.
Approximately 7.3% in the S&P 500 index ‘Spread’ method.
The bottom line is that by having a properly designed MEC, it is possible to achieve guaranteed positive returns net of all fees every year, while still having the ability to withdraw your money at any point in time.
There are still more benefits to consider.
Upon the policyholder’s death, the full proceeds of the MEC are left to an heir (or heirs) free and clear of taxes.
This can make MECs attractive for everything from estate planning to saving for younger family members’ college educations.
Some MECs offer a built-in Supplemental long-term care benefit that kicks in if the insured person is unable to perform two out of six daily living activities.
For someone concerned about soaring medical costs, this could be a nice feature. If you can’t perform 2 of the 6 activities of daily living, or you get a permanent cognitive impairment. The insurance company allows you to accelerate portions of your life insurance benefit while you are still living. In most cases this payout is tax-free.
Meanwhile, perhaps the biggest drawback is that the insured must go through medical underwriting (i.e. pass a physical examination) in order to get a policy written.
While this won’t be a problem for many people, applicants in poor health, or with serious diseases, would not be able to be the insured of a MEC. However, it is still possible to be the owner of a MEC with the life insurance benefit on someone other than yourself, provided you have an insurable interest in their lives. (Most of the time, clients can own a MEC on their spouse or adult children.)
MECs are not available to residents of New York.
Residents of the other 49 states need to simply apply for the MEC. If you happen to live in New York, you may still be able to get a MEC if you have interests in another state, such as a second residence or business. We will be glad to speak to you to see if your specific situation can qualify for a MEC.
One last concern: The possibility of an insurance company failing.
While it is rare occurrence for a life insurance company to fail, each state has a State Guaranty Fund which acts as insurance to insurance companies. Your money would be protected by your state’s particular guaranty fund and its associated rules and limitations.
We only recommend policies from A+ Rated insurers and largest in financial size. Each company we suggest has been in business for more than 100 years and boast very diversified business lines.
Call Moshe Fishman at 732-806-0017 or submit the form below to schedule a free consultation.