What Is a Modified Endowment Contract (MEC)?

A modified endowment contract (MEC) is a term given to a life insurance policy whose cumulative premiums exceed federal tax law limits. The taxation structure and IRS policy classification changes after a life insurance policy has morphed into a MEC.

When a policy becomes a MEC, the IRS no longer considers this a life insurance contract. The change in classification was enacted to combat the use of the “life insurance” designation for people looking to avoid paying taxes.

If your life insurance contract becomes a MEC, you’ll lose the life insurance policy tax benefits that are typically available before payment the death benefit.

A life insurance policy is considered a MEC by the IRS if it meets three criteria:

  • The policy is entered into on or after June 20, 1988.
  • It meets the statutory definition of a life insurance policy.
  • The policy fails to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.

That can be a significant problem for many people who invested in a permanent life insurance policy.

Every policy sold now is required to have an NAIC compliant illustration that outlines the years that a policy is at risk of becoming a MEC.

The illustration will also specify the seven-pay premium.  This is the maximum amount you can pay in additional cash in addition to premiums each month without triggering the MEC.

In the late 1970s, life insurance companies attempted to leverage the tax-advantaged status of cash value life insurance contracts.  They created products that allowed for the substantial accumulation of cash value.  This would then allow the policy owner to make sizeable tax-free withdrawals at any time.

Congress viewed these as tax shelters and decided to place a limit on the amount of money that could be put into a flexible premium cash value policy.

As a result, the “seven-pay test” rule was created as part of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).  In effect, this is what created the MEC.

Before TAMRA passed, all withdrawals from a cash value life insurance policy were taxed on a first-in-first-out (FIFO) basis.

The seven-pay test set a limit on the amount of premiums paid into a flexible premium cash value policy and still retain FIFO tax status on withdrawals.  Under this rule, all withdrawals were considered a tax-free return of principal up to the amount of premiums paid.

The IRS also has tax laws that outline the maximum amount of premium that can be paid into the policy.  Limits are based on the amount of level premium it would take to pay up the policy after seven years and supersede those of the seven-pay test codified in TAMRA.

A violation of the IRS limits results in the policy being reclassified to MEC status under federal tax law.

Any single premium cash value policy is now classified as a MEC policy.  Most life insurance companies will not let policyholders pay premiums that violate the seven-pay test. All flexible premium cash value policies have both an annual and a cumulative dollar limit for each policy, determined by the amount of death benefit and the age of the insured.

The MEC rules apply to life insurance contracts issued on or after June 21, 1988. Contracts issued before that date are grandfathered and not subject to the MEC test. Some policy changes can cause these contracts to lose their grandfathered status.  Those changes include death benefit increases that require evidence of insurability and the addition of certain rider benefits.

How does a Modified Endowment Contract work?

A strict set of criteria has been put in place by the IRS for a life insurance policy to qualify as a modified endowment contract.

The primary rule involves the seven-pay test put forth in the Technical and Miscellaneous Revenue Act of 1988.  This test determines whether the total premiums paid into a life insurance policy in the first seven years are more than what was required to have the policy fully paid up in seven years.  If the paid premiums exceed this amount, then a policy will become a MEC.

If you entered into a life insurance policy before June 20, 1988, you are not subject to the payment of premiums over the money allowed by federal laws.  But if you renew an older life insurance policy after this date, it will be considered a new policy and will be subjected to the seven-pay test.

One of the key benefits of permanent life insurance is that the cash value grows tax-deferred.  Withdrawals are taken out on a First-In, First-Out (FIFO) basis.  It means you can withdraw funds tax-free up to the cash value contributions you have paid in premiums.

If a policy becomes a MEC, this FIFO advantage goes away, and the policy is treated as a typical retirement instrument.  Withdrawals revert to Last-In, First-Out (LIFO).  This means distributions are paid from the interest on the cash value first, and they are taxed as regular income.

MEC withdrawals for people under 59.5 years of age are also subject to a 10% penalty, just like other distributions from retirement instruments such as a qualified annuity contract, IRA or 401(k).

Policy loans from the cash value are treated as ordinary income.  As a result, MEC loans may be subject to income tax as well.

Here’s a quick example.

Assume that the MEC limit for a policy is $,1500 each year for the first seven years of the contract.  You can pay $1,500 in premium each year without triggering the MEC status.  But if you go over that amount in any of the first seven years, it causes your total premium payments to exceed the MEC limit.  Your policy is then classified as a MEC.

Under MEC rules the premium cannot be paid more rapidly than the seven level annual MEC premiums.  A MEC status cannot be reversed by paying less premium in later policy years. In other words, you cannot pay $2,000 one year, and $1,000 the next to bring you back to premium limits.

Once a policy has failed the seven-pay test, it becomes a MEC and remains a MEC for the life of the policy. Even if you exchange the MEC policy for a new policy, the new policy will be a MEC.

Also, a policy that initially satisfied the seven-pay test may still become a MEC if the face amount is reduced or if there is a material change.

Modified Endowment Contract rules

Overall, three federal tax acts were passed to make sure that the income tax advantages of life insurance we not abused.

The first of these was the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). It was implemented to increase revenue in the United States through a combination of federal spending cuts, tax increases, and reform measures. It modified some parts of the Economic Recovery Tax Act of 1981 (ERTA).

The Deficit Reduction Act of 1984 (DEFRA) legislated a series of tax changes and was originally a part of the stalled Tax Reform Act of 1983.  This act tightened up the TEFRA rules by defining taxable versus nontaxable withdrawals.

The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) created MECs. This legislation further tightened the rules by enacting policy premium guidelines (the seven-pay test).  These prevent policyholders from paying a single premium or large amounts in early policy years and then borrowing the cash value tax-free.

Proper Use of Modified Endowment Contracts

MEC’s are used frequently as an estate planning tool. Banks often use these products to leverage a client’s legacy that they leave to their heirs.

Financial advisors often divide a client’s money into three categories: now, later, and never.

  • “Now” Money is invested in stable, short-term offerings. This includes money markets and CDs where it is easily accessed.
  • “Later” Money is typically invested in annuities or mutual funds that are geared to provide growth and income.
  • “Never” Money is usually a client’s liquid assets that they don’t intend to use during their lifetime. This last pot of money is where MECs can come in handy.

For example, a person with $100,000 in a CD that he intends to leave to his children could roll the balance over into a MEC when the CD matures. The investor will probably get a higher rate of interest in the MEC than he got in the CD.  Interest and growth also grow tax-deferred like in an IRA or annuity. When the person dies, the MEC pays out a tax-free death benefit.

MEC’s are useful estate planning tools for wealthy people with large estates and money they want to pass on to their heirs. They are often marketed as a stable retirement planning tool and touted as an alternative to annuities, which immediately become taxable when the owner dies.  MECs can be appropriate for investors looking to leave a tax-free inheritance to their family members.

Taxation of Modified Endowment Contracts

Here are some key points regarding MECs and tax implications:

  • Withdrawals from a MEC are taxed similarly to that of a non-qualified annuity withdrawal.
  • Once a flexible premium cash value life insurance policy is classified as a MEC, the policy loses its tax benefits, and the transformation cannot be reversed.
  • All withdrawals in a MEC are fully taxable as ordinary income to the extent of the growth in the contract.
  • Taxes on gains are regular income for MEC withdrawals using last-in-first-out(LIFO) accounting rules.
  • Withdrawing funds before the age of 59 ½ may trigger a premature withdrawal penalty of 10%.
  • Just like traditional life insurance policies, MEC death benefits are not subject to taxation.
  • Modified endowment contracts are usually purchased by people interested in tax-sheltered, investment-rich policies who do not intend to make pre-death policy withdrawals. The tax-free death benefit makes MECs attractive for estate planning purposes, as long as the estate can meet the qualifying criteria.
  • Policy owners who don’t take withdrawals can pass on a significant sum of money to their beneficiaries.

Pros and Cons of a Modified Endowment Contract

Here are some of the key advantages and disadvantages of a modified endowment contract:

The Pros

  • MECs are still life insurance offering tax-free death benefits and tax-deferred cash value accumulation.
  • If your policy becomes a MEC, and no distributions are taken during the insured person’s lifetime, you won’t experience any adverse tax implications.
  • A MEC provides liquidity. Despite tax implications, the cash value in the MEC can be accessed by withdrawing cash from a MEC policy, taking out a life insurance loan or surrendering paid-up additions for liquidity.
  • If you want to leverage a large sum of money into an even larger death benefit, depending on your age and the health, you may be able to get a return of more than 5-1 on your money. For example, if you have $100,000 and you want to put it into a single premium policy, your death benefit would probably exceed $500,000 and could be higher.
  • A MEC has advantages over other retirement vehicles because the death benefit from a MEC is free from probate for a named beneficiary. It is also incontestable and private. In many states, the benefits are also protected from creditors.
  • A MEC death benefit can be accelerated due to chronic illness, as a possible alternative or addition to long term care insurance.
  • Even if a policy is on track to become a MEC because of the payment of excess premiums, you can still avoid MEC status. This can happen if the insurer returns the excess premium paid, plus interest, within 60 days of the end of the year in which the excess occurs.

The Cons

  • Any pre-death distributions are taxed as “income first” meaning they are taxable to the extent of gain in the policy.
  • Distributions are subject to an additional 10% tax, except when the policyholder is 59 1⁄2 or older or has become disabled.
  • Potentially taxable distributions include policy loans, collateral assignments, cash dividends, dividends applied for any purpose other than to reduce the premium on the same contract, full and partial surrenders, and account withdrawals.
  • Money is tied up long-term unless you are willing to pay penalties.
  • A policy may be deliberately converted to a modified endowment contract. It can also happen by accident if certain rules are violated.
  • Using life insurance policies as an investment can be complicated, especially for people who normally only buy other less complicated types of investment vehicles. It’s always wise for people who own life insurance to do an annual review and ask for an ‘in-force illustration'” showing how planned investments are working out.
  • When a scheduled or an unscheduled reduction in the death benefit takes place in the first seven contract years, the seven-pay test is recalculated for the first seven years. It is done as if the contract had originally been issued at the reduced death benefit level.

What to do if a Contract Enters MEC Status

You are notified when your premium payment exceeds the seven-pay limit.  You can either accept the MEC classification or request a refund of the excess amount to avoid having the policy roll into a MEC.

If an excess premium payment is required to keep the policy in force, you may need to consider other options to satisfy the required premium.  This might include using policy values through partial surrenders or policy loans.  It’s best to explore these options with your insurance agent, attorney, or tax advisor.

Make sure you do so promptly because you must respond to a notification within the timeframe deadline that you were given.

As a reminder, once a policy converts to a MEC, the transformation cannot be reversed.  It can never become a life insurance policy again, regardless of the circumstances.

Also, a MEC cannot be transformed through an IRC 1035 exchange. A contract received in exchange for a MEC will also be a MEC.