Modified endowment contracts are life insurance policies where premiums exceed guidelines, resulting in rapid cash value growth. Prior to 1988, policyholders accessed tax-free policy loans, but the law was amended to tax distributions for anything other than death benefits. Cash value can be withdrawn or contracted at a prime rate of interest, but fees make withdrawal unattractive. The Seven Wages Test sets maximum allowable premiums for the first seven years, and corrective measures can be taken if exceeded. Changes in tax law discouraged modified endowment contracts as a short-term savings vehicle.
A modified endowment contract is a form of life insurance whose cash value grows rapidly due to large premium payments during the first seven years of the policy’s existence. Prior to 1988 in the United States, some policyholders took advantage of current tax laws to access their policy proceeds without paying taxes on them. In 1988, the law was amended to tax amounts distributed from modified endowment contracts for any purpose other than the payment of a death benefit to a beneficiary.
Cash value is a concept underlying whole life insurance policies and universal life insurance policies. Part of the periodic premium paid by the policyholder pays for the cost of insurance, and a small part pays for the administrative costs of maintaining the policy. The balance is held in a dedicated account called cash value, which grows from regular contributions of premium payments, as well as interest and dividends earned. That part becomes a policyholder asset that can be withdrawn (also by decreasing the death benefit) or contracted at a prime rate of interest. While the cash value of a policy can also be withdrawn, either in whole or in part, the fees imposed by the insurance company make this an unattractive alternative to a policy loan.
Traditionally, insurance proceeds are generally tax-exempt. This applies not only to death benefits paid, but also to loans, partial withdrawals, and full surrenders. Therefore, an insured could borrow against the cash value accumulated in a life insurance policy and not pay taxes on any part of the income.
In the high interest period of the early 1980s, many policyholders took advantage of this situation by making large premium payments, far more than was required to maintain their policies. What was not required to maintain the current policy was deposited in cash value, where it would grow at then-current rates, often approaching 20% per year. After a few years of such growth, they would take out tax-free policy loans and not pay them back, thus benefiting from the high interest rates without paying taxes on the gains.
In 1988, the United States Tax Code was amended to discourage this practice. A modified endowment contract was defined as any life insurance policy in which the premiums paid at any time during the first seven years exceeded the guidelines. These guidelines were established using a “Seven Wages Test,” which basically defines the maximum allowable premium per year that would provide the cost of insurance and modest cash value growth. If the total premiums paid at any time during those seven years exceeded the test standard, the entire policy was defined as a modified endowment contract. Corrective measures can be taken, but only for a short period of time; if it is not made, the determination is irrevocable and cannot be changed by any further action by the policyholder or insurer.
Changes in tax law in 1988 did not prohibit the modified endowment contract, but successfully discouraged its use as a short-term savings vehicle by imposing income taxes, and sometimes penalties, on any outlay of the cash value. other than the death benefit. Most insurance companies will monitor their life insurance policies and alert policyholders if a policy ever fails the seven-payment test and becomes a modified endowment contract.
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