How Life Insurance Cash Value Works and Its Role in Preventing MEC Status
Certain types of permanent life insurance—such as whole life, universal life, and indexed universal life—build cash value over time. This cash value is a living benefit within the policy, separate from the death benefit, that grows either at a fixed interest rate or based on market performance (depending on the policy type).
Building Cash Value
- Premium Contributions: A portion of each premium you pay goes toward the cash value.
- Tax-Deferred Growth: The cash value grows tax-deferred, meaning you don’t pay taxes on gains while they remain inside the policy.
- Access to Funds: You can borrow against your cash value or make withdrawals, often without triggering immediate taxes, as long as the policy remains in force and withdrawals are within the cost basis.
⸻
How Cash Value Can Keep a Policy from Becoming a MEC
A Modified Endowment Contract (MEC) occurs when a life insurance policy fails the IRS’s “7-Pay Test,” meaning it has been funded too quickly relative to its death benefit. Once classified as a MEC, policy loans and withdrawals lose their favorable tax treatment—earnings are taxed first, and early withdrawals may incur a penalty.
Insurance companies monitor policies closely to avoid MEC classification unless specifically requested. One way they do this is by using available cash value to cover the cost of insurance charges and other expenses if premium patterns risk pushing the policy toward MEC status. By adjusting how premiums are allocated and drawing from cash value when necessary, insurers can keep funding within the limits set by the 7-Pay Test.
⸻
Why This Matters to Policy Owners
- Preserves Tax Advantages: By preventing MEC classification, the policy retains its tax-free access to cash value through loans.
- Keeps the Policy in Force: Using cash value to cover costs ensures that the death benefit protection continues, even during periods when you may not pay premiums out-of-pocket.
- Maintains Flexibility: You can continue to use the cash value as a supplemental financial resource without triggering unintended tax consequences.
Insurance solutions to help meet a variety of goals.
Some retirees are concerned with the impact a market loss may have on the future of their income and assets. Others are looking for a reliable income stream. Still others actually underestimate the impact of a market loss.
For that reason, we offer a number of insurance solutions that can be used to protect more than just your physical assets. They can also be used to help protect your future. Whether they’re right for you depends on your unique retirement goals. Our firm helps individuals protect their retirement assets while still achieving growth by offering a variety of insurance products as part of a retirement strategy.
With the right strategy, you can potentially earn money with your money through the use of fixed annuities* and life insurance. Our firm can help you create a dependable and sustainable source of retirement income to be used now, in the future or whenever you need it most.
⸻
We offer the following services or can refer you to a trusted financial services professional who does:
- Fixed and Fixed Indexed Annuities
- Life Insurance
- Long-Term Care
- Health Insurance
- Medicare Supplements
Contact us to explore if one of our insurance solutions could fit within your retirement strategy.
*Annuities are designed to be long-term insurance products. Early withdrawals may impact annuity cash values and death benefits. Taxes are payable upon withdrawal of funds. An additional 10% IRS penalty may apply to withdrawals prior to age 59 ½. Income benefit riders may be offered either built-in or for an additional cost. Annuities are not guaranteed by FDIC or any other governmental agency. Keep in mind that most life insurance policies require health underwriting and, in some cases, financial underwriting. Guarantees are based on the claims paying ability of the issuing insurance company. Fixed Indexed Annuities are insurance products and not considered a security or investment. Some restrictions may apply. We are not endorsed by, or affiliated with, the Social Security Administration or any other government agency. Call for specific details and availability.
Life insurance may offer multi-faceted retirement strategies.
Although some people view life insurance as a way to replace lost income or pay off debt after a loved one passes, it also offers other potential benefits that may make it a valuable tool to help accomplish different financial goals in retirement.
First, life insurance may provide some degree of comfort for the policyholder (the insured) because their loved ones (the beneficiaries) will receive a death benefit when they pass away. Additionally, life insurance can be a tool for small business owners to help protect their business if something should happen to them.
⸻
In addition to a death benefit, life insurance is one of a few products that may help you reduce or avoid certain taxes. Some of these benefits may include:
Death benefits
- Policy death benefits may be income tax-free
- Some life insurance policies may allow the death benefit to accelerate before the insured’s death due to terminal or chronic illness, and that benefit may be income-tax free
Tax-free exchanges
- The insured may exchange their existing life insurance policy for a new policy and the gains on the original contract may be tax free
- The insured may exchange their existing life insurance policy for an annuity and the gains on the original contract may be tax free
Policy cash values
- Cash values may grow tax-deferred during the insured’s lifetime
- Income from cash value, when properly structured, may not be subject to income taxes
⸻
We’re able to shop dozens of insurance carriers to find rates and products that fit your specific needs and goals. That means we’re not relegated to simply one line of products or one brand name like a captive agent. In addition, we offer complimentary reviews on your existing life insurance contracts.
Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Policy loans and withdrawals will reduce available cash values and death benefits and may cause the policy to lapse or affect any guarantees against lapse. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Withdrawals are generally income tax-fee, unless the withdrawal amount exceeds the amount of premium paid. Policy loans are not usually subject to income tax unless the policy is classified as a modified endowment contract (MEC) under IRC Section 7702A. However, withdrawals or partial surrenders from a non-MEC policy are subject to income tax to the extent that the amount distributed exceeds the owner’s cost basis in the policy. Tax laws are subject to change. Clients should consult their tax professional. Keep in mind that most life insurance policies require health underwriting and, in some cases, financial underwriting.