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An endowment policy is a type of life insurance that provides two potential benefits: a death benefit if the insured dies during the policy term, or a maturity benefit equal to the face amount if the insured survives to the end of the term.
Endowment policies resemble whole life insurance but mature sooner. While whole life policies mature at age 100, endowment policies mature at a specified earlier date. For example, a $50,000 20-year endowment pays out (matures) after 20 years, versus a whole life policy that pays at age 100. Both policies pay the face value if the insured dies before the policy matures.
Key features of endowment policies include:
In 1988, Congress enacted the Technical and Miscellaneous Revenue Act, commonly referred to as TAMRA. Among other things, this act revised the tax law definition of a life insurance contract. The primary reason for its passage was to discourage the sale and purchase of life insurance for investment purposes or as a tax shelter. A modified endowment contract (MEC) is a whole life insurance policy that, according to IRS tables, is considered overfunded and, as such, is not truly a life insurance policy.
Any life insurance policy that's purchased after June 20, 1988, is considered by the IRS to be an MEC if it doesn't satisfy the seven-pay test. The seven-pay test is a limitation on the total amount a person can pay into a policy in the first seven years of its existence. A whole life insurance policy is a modified endowment contract if the total amount of premiums paid during the first seven years of the contract exceeds the total amount of premiums required for the same insurance policy to be paid up in seven years. The purpose of the test is to discourage premium schedules that could result in a paid-up policy before the end of a seven-year period. All single-premium whole life policies are modified endowment contracts. Once a contract is declared an MEC, it can never revert to ordinary insurance. However, if there's a material change in the contract, the seven-pay test applies again.
The following are illustrations of the tax treatment of benefit distributions from an MEC:
For example, meet Robert, a 45-year-old software engineer who received a $200,000 bonus and consults his insurance agent, Sarah, about two whole life options: a traditional policy with a $500,000 death benefit and $12,000 annual premiums (a seven-year total of $84,000, which meets the seven-pay test), or an accelerated premium policy with the same $500,000 death benefit but a $100,000 first-year premium followed by $5,000 annually (a seven-year total of $130,000, which exceeds the seven-pay test limits and triggers MEC status). Five years later, Robert needs $30,000 for his daughter's college tuition and takes a policy loan. If he had chosen the traditional policy, the loan has no immediate tax consequences, can be repaid at his convenience, carries no early withdrawal penalty, and the cash value continues to grow. If he had chosen the MEC policy instead, the same $30,000 loan triggers immediate taxation on any gain in the policy, an additional 10% penalty tax (since he's under 59½), less favorable tax treatment on future withdrawals, and reduced flexibility in accessing funds. This scenario illustrates how MECs can substantially affect a policyholder's ability to access funds tax-efficiently and underscores the importance of understanding the seven-pay test when structuring life insurance policies.
A face amount plus cash value policy is a contract that promises to pay the policy's face amount plus the policy's cash value upon the death of the insured. This type of insurance policy requires a substantially higher premium than its traditional counterpart, and as a result, the policy is not standard within the insurance industry.
This policy can provide financial benefits if an insured is killed, loses a limb, suffers blindness, or is paralyzed in a covered accident.
Nonmedical life insurance doesn't require a medical exam and tends to be more expensive than medically underwritten policies. The insurer will average out everyone's risk and charge accordingly. Although insurers typically will not require a medical exam, they will still inquire about the applicant's medical history and lifestyle.
A participating life insurance policy is a type of life insurance policy that receives dividend payments from a mutual life insurance company. It is referred to as participating because the policyowner is permitted to share or "participate" in the excess earnings of the life insurance company. A nonparticipating policy does not share excess earnings, and consequently, policyowners do not receive dividend payments. Stock insurers issue nonparticipating policies.
Stranger-owned life insurance (STOLI) is essentially a scheme whereby strangers to the insured — those without any true insurable interest — originate a policy for their own financial gain. Simply put, these schemes are wagers on human life and are prohibited in most states. To legally purchase life insurance on another person, the purchaser must have an insurable interest in that person's life. STOLI policies were a way to circumvent the insurable interest requirement when purchasing a life insurance policy.
Investor-owned life insurance (IOLI) is a life insurance policy that covers the life of an individual who is unrelated to the policy owner, either by familial or economic relationship. The investor pays the person's premiums in exchange for the person's life insurance benefits. An IOLI transaction is very closely related to a STOLI transaction. The primary difference between the two is that an investor always initiates an IOLI.
Both STOLIs and IOLIs are considered fraudulent. STOLIs and IOLIs do not include lawful life settlement contracts, provided that such contracts or practices are not for the purpose of evading regulation.