Single Premium Life Insurance: Is a Lump Sum Policy Right for Your Financial Strategy?

MEC Taxation Rules

A life insurance contract which fails to pass a TAMRA 7-pay test is classified as a modified endowment contract due to cash contributions to the policy that exceed IRS limits. A major difference between MEC and non-MEC policies under IRC 7702 is the tax treatment of policy loans and withdrawals.

Policies classified as modified endowment contracts are subject to last in first out (LIFO) taxation from the IRS, meaning that taxes must typically be paid on any withdrawals from a cash account that has grown in value.

In addition, if you withdraw funds from a MEC policy prior to the attaining age 59½, penalties for early withdrawal apply, similar to the penalties you would pay for early 401k withdrawals.

As with 401k accounts, in certain cases you can withdraw funds from a modified endowment contract before age 59½ without penalty, for instance in the case of a 72T provision.

Traditional participating whole life insurance policies, on the other hand, allow for partial withdrawals tax and penalty-free up to the amount of your contributions to the policy, also known as your “basis” in the policy.

Understanding the 7-Pay Test

The 7-pay test, established by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), determines whether a life insurance policy is classified as a MEC. Under this test, a policy becomes a MEC if the premiums paid exceed the amount required to make the policy paid-up within seven years.

Since single premium policies are funded with one large payment upfront, they automatically fail the 7-pay test and are classified as MECs. This classification is important to understand because it affects how policy withdrawals and loans are taxed.

Key Similarities

• A death benefit that is paid, typically free of taxes, to your beneficiary or beneficiaries
• Guaranteed growth of the cash value account
• If the policy is offered by a mutual life insurance company you can earn dividends
• Funds in the cash account grow tax-deferred
• Funds can be withdrawn via policy loans or partial withdrawals
• Protection from probate and privacy benefits
• Potential creditor protection depending on state laws

Important Differences

• Tax Treatment: Single Pay contracts are LIFO; Whole Life contracts are FIFO
• Early Withdrawal: Single Pay contracts withdrawals may incur a 10% penalty before age 59½; Whole life contracts have no such penalties
• Premium Structure: Single Pay requires one large payment; Whole Life allows for ongoing payments
• Liquidity Access: Single Pay has less favorable tax treatment when accessing cash value during lifetime
• Flexibility: Traditional policies offer more options for adjusting premiums over time

Peace of Mind

One major reason, as previously mentioned, is the convenience and peace of mind created by owning a fully funded life insurance policy, which eliminates any fear of your policy lapsing at some point due to failure to pay premiums.

Alternative Savings Vehicle

Another advantage of a single premium life insurance policy is the ability of these policies to act as an alternate savings vehicle offering returns that are competitive to other tax-favored investments.

A single premium life insurance policy, in effect, functions like an annuity contract that includes life insurance protection. As with a single premium immediate annuity, the most effective approach from a tax perspective is to avoid taking loans or withdrawals from such a policy until you reach age 59½. The same applies to any policy dividends, which may be taxable if taken in cash.

Potential Higher Returns

While traditional whole life policies also feature cash value account growth, a single premium whole life insurance policy may provide better performance in terms of internal rate of return as compared to a standard policy with the same level of insurance coverage. These policies typically can turn in a positive rate of return at least by the time the surrender charge has evaporated, if not sooner.

Tax Deferral Benefits

Single premium life insurance policies are often purchased by those who are seeking a policy that enables them to defer taxation and who don’t plan to take withdrawals from the policy, using it primarily for the tax free death benefit. If you plan to pass a significant sum on to your heirs or a charity, a modified endowment contract can be an efficient means of doing so.

Emergency Fund

Another reason for purchasing single premium life insurance is to gain the security of paid-up life insurance with cash value you can access in a pinch. Even if you have done a good job of setting aside money for retirement already, a single premium policy’s cash value can provide emergency funds if they are needed, albeit with potential tax consequences and penalties for early withdrawal.

Living Benefits

Additionally, the availability in recent years of single premium life insurance policies with accelerated death benefit riders that contain long-term care benefits has made these policies attractive as a long-term care (LTC) option in place of long-term care insurance.

Such long-term care riders, which are subject to underwriting approval and may be unavailable in some states, usually enable you access to part of the death benefit upon the occurrence of certain events.

Living Benefit Riders may include:

• Chronic illnesses which leave the insured unable to perform 2 or more activities of daily living, therefore requiring continuous care
• Accelerated death benefit allowing you to access the death benefit tax free upon diagnosis of terminal illness
• Specified medical conditions like cancer or potentially fatal cardiac disease

The ability to use a single premium life insurance as a combination life insurance policy/LTC rider solution with accelerated death benefits makes such policies truly flexible financial planning tools.

If you don’t require access to the LTC or accelerated death benefits such policies can offer, you can experience significant growth in your cash value account over time.

Whole life policies, especially dividend-paying policies offered by mutual life insurance companies have typically performed quite well when compared against bank savings accounts and CDs in recent years in terms of internal rate of return.

And if you experience medical emergencies or require long-term care, you can use a portion of the policy’s death benefit to deal with these conditions.

Furthermore, if you need access to your funds for any other reason, you can do so via a policy loan or partial withdrawal, as long as you are aware of the potential consequences in terms of taxes and penalties.

Financial Aid

Another advantage of a single premium life insurance policy is that it can help a child qualify for financial aid. Money held in an insurance policy, unlike funds contained in a 529 account, is not counted as part of the parents’ available assets when it comes to computing a child’s eligibility for financial aid.

7-Pay Whole Life Insurance Policy

You can choose a 7-pay whole life insurance policy with an initial lump sum payment. A properly structured whole life insurance policy built for maximum cash value growth can be designed so that your initial premium payment is a larger payment. From there, you would have a premium schedule for 7 years total that would allow you to have the policy become fully paid-up life insurance, with no more payments due, but you would avoid the policy becoming a MEC.

A 1035 exchange from another insurance policy or an annuity:

A 1035 exchange may work in certain cases, but, in many cases, is not the optimal approach, given that it is often better to change an old insurance policy rather than replacing it in order to reduce or end the need to continue making payments on it.

However, in cases where you have built up cash value in a policy that is not right for your current circumstances, such an option enables you to convert that policy to a single premium life insurance policy that will not be classified as a MEC if the original policy was not considered a MEC.

Whole life non-MEC pre-paid premium policies:

It is possible to establish a non-MEC policy with one or two “pre-paid” payments. Part of the payment is kept in an account sponsored by the life insurance company that pays interest and is then added to the policy at a later time to prevent the policy being designated as a MEC.

Using a bridge loan to fund a whole life policy:

This approach involves placing a lump sum into a bridge loan contract, or several such contracts, that pay out cash flow on a monthly basis. This cash flow is then used to buy a non-MEC whole life insurance policy.

This strategy is subject to factors such as your age and health, among others, and offers the potential to provide you with greater growth and flexibility than would be the case if you simply used the cash to purchase a MEC.

Get Your Personalized Single Premium Life Insurance Analysis

Before deciding if a single premium policy is right for your financial strategy, get a customized analysis from our expert team. We’ll help you understand if this approach aligns with your wealth and legacy planning goals.

• ✓ Compare single premium options with alternatives like 7-pay whole life
• ✓ Understand the tax implications for your specific financial situation
• ✓ Explore strategies to maximize death benefit and living benefits
• ✓ Get answers to your specific questions about lump sum policies

Schedule your complimentary 30-minute strategy session today and take the first step toward informed life insurance planning.

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