“Pay cash up front or make easy monthly payments?” When it comes to homes, cars, cell phones and other purchases, oftentimes, people choose payments. And so it is with life insurance; making “payments” in the form of long-term premiums is the common way to create and build a life insurance asset.
And yet, for those who are able… “One and done” has its appeal! Some people just LOVE the idea of being able to make ONE big life insurance payment and be done with it forever.
There are many pros and cons to consider when evaluating single premium whole life. We find that some clients choose something different after we help them consider multiple options, but it can be a good fit for others.
In this article, we’ll examine the pros and cons of single premium whole life insurance, or SPWL policies. We’ll also give some concrete examples of premiums and benefits to demonstrate how they work, and we’ll name some “MEC alternatives” as well. But first, let’s understand perhaps the primary difference between a traditional life insurance policy and a SPWL.
The Modified Endowment Contract
By definition, a single premium whole life policy is a Modified Endowment Contract, or MEC, if entered into past June 20, 1988. A MEC is defined as such because it exceeds the IRS limits (based on a “7-pay test”) for the amount of cash a policyholder can put into a life insurance contract.
Single premium insurance contracts typically begin as MECs. Other policies can become MECs if the allowable amount is exceeded (perhaps through excess paid-up additions) and not promptly removed.
There are many similarities between traditional whole life policies and MECs, including SPWL policies. Both MEC and non-MEC whole life policies:
- are permanent life insurance contracts with both a death benefit and cash value;
- have guaranteed cash value growth;
- allow cash value to be borrowed against and even withdrawn;
- grow cash value tax-deferred;
- can earn dividends (not guaranteed, but historically reliable for over 100 years) if policies are from mutual companies; and
- deliver a tax-free death benefit to beneficiaries, except in cases when the life insurance proceeds are part of an estate and the estate is subject to taxes.
In spite of the similarities, when it comes to withdrawals and policy loans, a MEC is taxed differently from a non-MEC policy, a primary reason MECs are seen as less desirable. When the IRS classifies a policy as a MEC, it changes the order of taxation within the contract, taxing money withdrawn or borrowed through policy loans according to last-in-first-out (LILO, or “gain first”) accounting rules. Additionally, a MEC owner pays penalties for withdrawals before the age of 59-1/2, not unlike a traditional 401(k), IRA, or a non-qualified annuity. (There can be circumstances in which a withdrawal before age 59-1/2 is not penalized, such as for a medical event in accordance with a contract rider, or for withdrawals under a 72T provision.)
By contrast, withdrawals from non-MEC life insurance policies operate under first-in-first-out (FIFO) rules, which makes withdrawals up to the basis non-taxable. Non-MEC policy loans are typically tax-free and penalty-free.
So, Why Would Someone Want a MEC?
With such restrictions, who would want a MEC? Typically, they are purchased by people or even institutions who want a tax-sheltered, investment-rich policy, and don’t intend to make pre-death policy withdrawals. For instance, if you have received a windfall and your primary goal is to maximize and pass that windfall along to beneficiaries or a charity, rather than utilize it yourself, a MEC is a valid choice.
People who want MECs also may not want continuing premium payments for various reasons. Or perhaps they feel “well set” for retirement, but still hesitant to tie up their money in illiquid assets. If you have accumulated assets that you wish to safely multiply while maintaining some level of flexibility should you unexpectedly need access to capital, an SPWL might be considered.
SPWL policies are also growing in popularity with the advent of accelerated death benefit riders offering potential long-term care benefits, which make the policies an attractive alternative to LTC insurance for many.
Banks consider MECs to be worth the potential disadvantages. We wrote several weeks ago about the trend of bank-owned life insurance (BOLI), in which banks have put more than $160 billion into life insurance contracts. Most of these BOLI contracts are single premium MECs which add to a bank’s tier-one capital balance sheet.
Policies can also become MECs accidentally through overpayment of premiums through paid-up addition riders, although life insurance companies do monitor this and will notify a policy owner and allow them to return overpayments so that the policy does not become a MEC.
Advantages of Single Premium Whole Life
The main feature of an SPWL is no more payments, which means
- no budgeting, planning, or fretting about your future ability to pay
- zero risk of ever defaulting on your life insurance, and
- nothing to do, nothing to manage.
Long-term care and other living benefits.
This is where SPWL policies excel. We now offer an SPWL policy that includes riders (at no extra cost), riders that allow policyholders to access a portion of their own death benefit when triggered by a qualifying event, such as:
- Terminal illness diagnosis,
- Chronic Illness (including dementia or Alzheimer’s Disease) in which the insured becomes unable to perform 2 or more “activities of daily living” (ADLs) and ongoing care will be required, or
- Specified Medical Condition, such as a stroke or life-threatening cancer.
(Note: accelerated benefit and LTC riders are subject to underwriting approval and may not be available on SPWL every state, although nearly all states have now approved them.)
In this way, an SPWL with an Accelerated Death Benefit/LTC rider can help you prepare for ANY future scenario:
- Live a long and healthy life? You’ve safely multiplied a lump sum (that continues to grow) that your beneficiaries will receive in the form of an eventual income-tax free death benefit.
- If you encounter a terminal or chronic illness, or major medical event, you can use the benefits specific by your policy which could include accessing part of your death benefit in either a lump sum or payments.
- Need or want to access money for ANY reason? You can always withdraw or borrow against your cash value. Just be aware of the tax consequences and possible penalty.
Grows cash quickly and safely.
The internal rate of return often outperforms bank savings accounts and certificates of deposit by 200 – 300 basis points. With an SPWL, the cash value surpasses the premium paid after the first couple of years and internal rates of return may be higher than non-MEC policies.
Multiplies your money.
A single premium life insurance policy turns your premium into a significantly larger asset… instantly. Depending on your age and health and other factors, you might see your windfall double, triple, or quadruple over time.
EXAMPLE: We ran a sample illustration on a 60-year old woman, summarized below, showing the guaranteed minimum cash value and death benefit, plus the predicted cash value and death benefit based on the current dividend scale:
(Want to see a complete illustration tailored for you? Contact Partners for Prosperity for an illustration of a Single Premium whole life policy or non-MEC hhigh-cash-value whole life policy.)
Financial Aid readiness.
If you have a child applying for federal financial aid through the FAFSA, money held in 529 accounts and many other financial vehicles will be counted as assets that can reduce a student’s financial aid qualification. Moving a lump sum of money into life insurance can help a student qualify for financial aid because—similar to a parent’s retirement accounts— life insurance is not counted as an available asset.
How important is the single premium?
Before we look at some disadvantages, let’s examine one half-truth: the advantage of the single payment. Are payments really so inflexible as people think? With a traditional, multi-year whole life policy, do you really have no flexibility, no ability to miss payments without losing your policy? Not at all. The truth is that once you get past the couple of years of a policy, there is a LOT of flexibility.
Our family has quite a few whole life policies (I have several myself!) and during the Great Recession, we used that flexibility ourselves to temporarily halt making premium payments… for years! We used an automatic premium loan, but there are many ways to keep the life insurance policy going even if you need to take a break from making payments. We give details in our article, “7 Ways to Save a Life Insurance Policy (even if you can’t afford the premiums).”
In our perspective, often the concern over whole life payments is overblown. After all, many people make monthly payments for their cell phones, cable bill, car payments, mortgage payments, utilities, gym memberships, car insurance, and other things for decades, if not for life, often without building equity they can use! And unlike a whole life insurance policy, many of those items have little flexibility.
Of course, this doesn’t mean that a multi-year policy is always the best choice. If purchasing a whole life policy in one payment is important to you, that factor might outweigh the potential disadvantages.
The Disadvantages of Single Premium Whole Life Insurance
To summarize some of the points made in our MEC discussion:
- Withdrawals and even policy loans are often subject to income tax;
- Withdrawals and loans can incur penalties prior to age 59-1/2;
- There is also an opportunity cost to paying the entire premium up front, so consider if an SPWL is the best use of a lump sum.
If you don’t plan on withdrawing or borrowing against your cash value, a MEC might work for you. But there are other options, even if you don’t want to make years of payments….
“MEC Alternatives” (that don’t require ongoing premiums)
The following options can turn a lump sum (or two) into life insurance benefits without becoming MECs:
- Pre-paid premium non-MEC whole life policies. Whether you make a single payment or two payments, there are options for non-MEC policies in which you “pre-pay” your premiums. A portion of your payment(s) is then held in an interest-bearing account with the insurance company and later put into the policy so that the policy does not become a MEC.
- 1035 Exchange from an annuity or a different policy. In rare circumstances, this can work, although annuities tend to have hefty surrender charges, and replacing an old whole life policy with a new one doesn’t make mathematical sense (you’re better off altering the old policy if you wish to stop or reduce payments). But if you have built cash value in a policy that is not ideal, such as a Universal Life policy that could become problematic due to increasing mortality costs (see “The Inconvenient Truth About the Other Permanent Insurance”), you can exchange the surrender value in that policy for a new SPWL. If the entire premium is in the form of a 1035 Tax Exchange and the original policy was not be a MEC, the new policy will be issued as a non-MEC.
- Bridge Loan funding a whole life policy. One strategy that works well for some people is to put the lump sum into one or more bridge loan contracts that will generate monthly cash flow. Then use the cash flow from the asset to purchase a non-MEC whole life policy. Depending on age, health and other factors, this strategy could give you an even higher estate worth and greater flexibility than simply converting the lump sum of cash into a MEC!
Get the Facts of Life Insurance!
Want to see some personalized illustrations? Discuss your options? Perhaps you’d even like to see the internal rates of return computed on a financial calculator? Contact us today–We are here to help! You won’t get a sales presentation, but you will get the facts and all of your questions answered. Author of two best-selling books on life insurance, Kim Butler and her team are the “Wealth Without Wall Street” experts!
Listen to The Prosperity Podcast for More:
Read Kim’s books on Life Insurance
You’ll find Live Your Life Insurance (a great overview on building wealth you can use with life insurance, Busting the Life Insurance Lies (a more comprehensive book answering 37 questions about life insurance), plus all of Kim’s books on Amazon here.