The Trick: Keep away from MEC Standing
As with all issues that sound too good to be true, you’re most likely questioning: what’s the catch? And there’s one – so should you Googled “what’s an overfunded life insurance coverage coverage” hoping to discover a get-rich-quick scheme, this isn’t it.
Due to the tax advantages of overfunding your coverage, the IRS put guidelines in place governing how and when you may overfund and nonetheless reap all these advantages.
IRS rule 7702 is designed to maintain you from overfunding your account for the primary seven years you personal the coverage. Throughout that point, should you overfund your account with greater than your required funds, your coverage may very well be reclassified as a modified endowment contract (MEC). As soon as your coverage is reclassified, the tax advantages for money worth are enormously diminished:
- Non-MEC: You possibly can entry your money worth through a withdrawal or coverage mortgage as much as the quantity you’ve paid into the coverage with zero revenue tax obligation. In case you pull out greater than you’ve put in, you solely owe revenue tax on the overage. Whereas in your account, the cash continues to develop tax-deferred.
- MEC: Any money worth you pull out through a withdrawal or coverage mortgage can be topic to revenue tax, irrespective of how a lot you’ve paid into the coverage. Whereas nonetheless in your account, nonetheless, the cash continues to develop tax-deferred.
Your finest technique? Wait out the primary seven years, throughout which the IRS rule 7702 applies. After that time, you may contribute as a lot as you wish to overfund your coverage with out the concern that it may very well be reclassified.
If you wish to use whole life insurance to grow wealth, for instance, it’s key to make certain your coverage is just not structured as a MEC from the get-go, and to keep away from doing something that might set off that reclassification.
