The use of life insurance as a tax avoidance became popular but Congress put an end to it by passing three laws. The first was TEFRA, Tax Equity and Fiscal Responsibility Act in1982, which established some minimum guidelines on amount of payment and death benefit. Next DEFRA, Deficit Reduction Act of 1984 refined the tax law and established taxable and non-taxable withdrawals from contracts. Finally, TAMRA, Technical and Miscellaneous Revenue Act of 1988 established the guidelines for early year's premium and tax-free borrowing later in the contract life.
Step 1
Conduct the seven-pay test on the policy using the premium shown for that amount of insurance. The seven-pay test compares the premium paid into the policy in the first seven years with the amount paid into a seven-year paid up whole life policy of the same death benefit. Because the test uses interest, expense and mortality assumptions it isn't about actual net level premium and even a regular seven-pay life might fail the test since the assumed premium used for the test might be less.
Step 2
Fail the seven-pay test at any point and the policy becomes a MEC, modified endowment contract. Once a policy is a MEC, it is always a MEC even if the company or policyholder makes corrections and adjustments to it.
Step 3
Use the tax rules for annuities if the policy is a MEC. Taxation rules for annuities are LIFO, last in first out. This means that the last in is always interest and growth, so anything removed is interest first and taxable. A 10 percent penalty applies to the growth if the person is younger than 59 1/2. Policy loans become taxable even if you use them to pay premiums. If you use the policy to secure a bank loan, there's also incidence of taxation. Even assignment of a policy becomes a taxable incident.
Step 4
Lose the "grandfathered" status if you make a material change in the policy. Any policy purchased before June 21, 1988, are exempt from MEC rules unless there's a material change to it. Material changes include death benefit changes, changes in a rating or even changing from smoker to non-smoker status. At that point, the insurance company must retest the grandfathered contract.
Step 5
Retest the contract when you make any material changes to it. Again, material changes might be as simple as changing a rating or converting term insurance to permanent insurance. A 1035 exchange into a new policy might trigger a retest.
Step 6
Forget the test if the change is nothing more than increasing payments to fund the minimum death benefit, cost of living increases, increases due to interest applied or dividends, changes because of financial difficulties of the insurer or adding a long-term care rider.