Modified Endowment Contract - MEC

What is a 'Modified Endowment Contract - MEC'

A modified endowment contract (MEC) is a tax qualification of a life insurance policy where the policy has been funded with more money than allowed under federal laws. If the cumulative premium payments exceed certain amounts specified under the Internal Revenue Code, the life insurance policy becomes a modified endowment contract.

BREAKING DOWN 'Modified Endowment Contract - MEC'

Taxation under an MEC is similar to taxation under an annuity. Under an MEC, the death benefit payable to the beneficiary is not subject to income tax. An MEC is usually bought by individuals who are interested in a tax-sheltered, investment-rich policy, and do not intend to make pre-death policy withdrawals.

A life insurance policy that becomes an MEC is no longer considered life insurance by the IRS; MECs are essentially treated like nonqualifying annuities for tax purposes. This reclassification to an MEC changes the ways in which the IRS taxes money withdrawn, and can result in penalties for a life insurance owner if the owner makes a withdrawal before the age of 59.5.

Criteria for Becoming an MEC

Specifically, a life insurance policy is considered an MEC by the IRS if three conditions are met. First, the policy was entered into after June 20, 1988. Second, it meets the statutory definition of a life insurance policy. Third, the policy must fail to meet the 7-pay test.

Life insurance policies entered into prior to June 20, 1988, are not subject to the payment of premiums in excess of the money allowed under federal laws. However, if an older life insurance policy is renewed after this date, it is considered new and must be assessed with the 7-pay test.

The 7-pay test is assessed by calculating if the total amount of premiums paid into a life insurance policy by the holder within the first seven years exceed the amount of premiums required to have the policy be considered paid up in seven years. If the premiums paid exceed the amount required, then the life insurance policy is considered an MEC.

Tax Implications of an MEC

Unlike traditional life insurance policies, MECs have gains taxed first on any withdrawals under LIFO accounting. Further, any withdrawal made by the policyholder prior to the age of 59.5 is assessed with a 10% tax penalty. However, the cost basis of the MEC and the withdrawal are both not subject to taxation. Finally, even MECs have death benefits that pass onto the beneficiaries tax-free. This makes MECs useful for estate planning purposes. Since the death benefit is tax-free, policy owners who do not expect any early withdrawals are not subject to additional taxes and can pass on a significant sum of money to their beneficiaries.

RELATED TERMS
  1. Section 1035 Exchange

    A tax-free exchange of an existing annuity contract for a new ...
  2. Term Life Insurance

    A policy with a set duration limit on the coverage period. Once ...
  3. Section 7702

    The section of the United States Internal Revenue Code that defines ...
  4. Permanent Life Insurance

    An umbrella term for life insurance plans that do not expire ...
  5. Guaranteed Issue Life Insurance ...

    A type of financial-protection policy that provides cash to a ...
  6. Death Benefit

    The amount on a life insurance policy or pension that is payable ...
Related Articles
  1. Personal Finance

    Insurance: Avoiding The Modified Endowment Contract Trap

    Congress has placed limits on the amount of money that can be put into life insurance policies - what can you do to counteract this?
  2. Personal Finance

    Avoiding The Modified Endowment Contract Trap

    To avoid MEC status, flexible-premium policies must cap the amount that can be paid into the policy over a period of seven years.
  3. Personal Finance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  4. Retirement

    Understanding Life Insurance Premiums

    When buying permanent life insurance, what amount of premium should you pay for the coverage?
  5. Personal Finance

    Mistakes to Avoid When You Own Life Insurance

    How to avoid some common mistakes that can cause tax and inheritance problems when you own life insurance.
  6. Financial Advisor

    Advising FAs: Explaining Life Insurance to a Client

    Life insurance was initially designed to protect the income of families, particularly young families in the wealth accumulation phase, in the event of the head of household's death.
  7. Personal Finance

    Understanding Taxes on Life Insurance Premiums

    Learn about the tax implications of life insurance premiums, including when they might be taxable and whether they are tax deductible.
  8. Retirement

    Why the Wealthy Should Buy Lots of Life Insurance

    Wealthy clients have an enviable problem — managing, preserving and growing wealth. Properly structured life insurance can help with these goals.
  9. ETFs & Mutual Funds

    Life Insurance

    What life insurance is: A contract with an insurance company that provides your beneficiaries with a certain amount of money when you die. Pros: Beneficiaries are safeguarded from the financial ...
  10. Personal Finance

    Getting Life Insurance in Your 20s Pays Off

    Find out how Americans in their 20s can benefit from a well-thought-out life insurance policy, especially if they are able to build cash value for retirement.
RELATED FAQS
  1. What is the ratio of life coverage to cash value before the IRS declares receipts ...

    I own a participating/dividend paying whole life policy with a mutual fund company.      ... Read Answer >>
  2. Do beneficiaries pay taxes on life insurance?

  3. How can I borrow money from my life insurance policy?

  4. What is the difference between the death benefit and cash value of an insurance policy?

    Understand the difference between the various components of a life insurance policy including the death benefit and a policy's ... Read Answer >>
  5. What is a tax-free 1035 Exchange?

  6. How much are the taxes on a $10,000 life insurance policy?

    The owner of the policy is deceased.  ... Read Answer >>
Trading Center