Sunday, January 21, 2007

Endowment Insurance and Modified Endowment

Prior to Tax Reform Act of 1984, there was a growing popularity of purchasing Endowment Insurance. Like other life insurance, the policy will pay the death benefit if the insured dies within the policy period. What makes it different from other life insurance is that it also pays if the insured lives to the end of the policy period. Like Whole Life, Endowment contracts combine the features of equity growth and protection with more emphasis on the build up of equity in the cash value.

Endowment contracts can mature in either two circumstances. It will pay a death benefit if the insured dies within the endowment period OR it will pay the cash value that is equal to the face amount if the insured lives to the endowment date. Therefore, the cash value must be build at an accelerated rate so that by the end of the policy period, the cash value would equal the face value that is payable to the insured.

Let's say that you bought a 10 Year Endowment policy in 1983 with $50,000 coverage. If you die on or before 1993, your beneficiary will receive the $50,000. If you live after 1993, you will receive $50,000 and no longer be covered.

As you can see, this product sounds very good because there is rapid growth of cash value, your cash value grows tax-deferred, and there is possibility of escaping income taxes if the insured dies and the proceeds were paid as a death benefit. But the disadvantages of having this policy is that you need to pay lots of premiums and you will owe income taxes if you live to the endowment date or age.

Let's say you bought an Endowment at age 65 policy with $100,000 policy. Over the life contract, assume you paid a total of $70,000 of premiums into the policy. When you receive the $100,000, the IRS will tax you the difference between what you paid and what you received, which is $30,000.

In 1984, the marketing of Endowment Insurance ended under the 1984 Tax Reform Act. Since the contract placed more emphasis on accumulation of cash value and relatively little emphasis on death protection, the product was viewed more an as investment contract rather than a life insurance policy. The act says that the cash value in a contract can build no faster than to equal to the face value when the insured reaches age 95. If any policy builds cash value more rapidly than this benchmark, it loses most or all of its tax advantages such as tax deferred growth and no income tax on death benefit.


4 years later after the 1984 Tax Reform Act, Congress pass another act in 1988 called Technical and Miscellaneous Revenue Act. This law says that if a policy creates a cash value faster than that of 7-pay Whole Life Policy, then the policy is a Modified Endowment Contract. Whether its Whole Life, Universal Life, or Variable Life, if the cash value grows faster than a 7-Pay Whole Life policy, then any loan or withdrawal must be made with the understanding that taxable dollars comes out first, then the return premium (which are made with after-tax dollars) dollars. Furthermore, there is a 10% penalty in addition to any taxes due on all withdrawals prior to age 59 1/2.

So if you are trying to accelerate the cash value, don't accelerate too much on what it should be in 7 years. For example, if the cash value is suppose to worth $3000 in 7 years, and you put in more premiums to accelerate the growth, your cash value may be worth more than $3000 in 7 years. If it does, your policy is now a Modified Endowment Contract and it will stay that way for life of the contract.