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 This reclassification to an MEC changes the ways in which the IRS taxes money withdrawn, and can result in penalties for a life insurance owner if the owner makes a withdrawal before the age of 59.5.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.

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