Avoiding The Modified Endowment Contract Trap

Cash-value life insurance has always provided consumers with a tax-free avenue of growth within the policy that could be accessed at any time, for any reason.

But Congress has placed limits on the amount of money that can be put into these instruments, and all cash-value policies are now subject to what is the seven-pay test (also written as the "7 pay test"), which limits the tax benefits of cash-value withdrawals. Life insurance policies that fail this test are now classified as modified endowment contracts (MEC). 

History of Modified Endowment Contracts (MECs)

Tax-free growth is one of the chief advantages of cash-value life insurance, and therefore many life insurance carriers tried to take advantage of this feature in the late 1970s by offering single-premium and universal life products that featured substantial cash-value accumulation.

Policy owners could then withdraw both the interest and principal as a tax-free loan, as long as the policy did not lapse before the owner's death. Of course, this strategy effectively allowed the policy to function as a large-scale tax shelter. However, Congress did not agree that life insurance should be used in this manner and therefore passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).

This act created the MEC. Before this law was passed, all withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. This meant the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. But TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive FIFO tax treatment. Any policy that receives premiums in excess of these limits automatically becomes a MEC.

The Corridor Rule

In a general sense, the corridor rule states that for any life insurance policy to avoid being classified as an MEC, there must be a "corridor" of difference in dollar value between the death benefit and the cash value of the policy. All single-premium policies are now classified as MECs. Flexible-premium policies must pass the seven-pay test in order to avoid MEC status. This test caps the amount of premium that can be paid into a flexible-premium policy over a period of seven years.

Each policy that is now issued will have its own MEC premium limit that is based on several factors, including the age of the policy owner and the face amount of the policy. Any premium paid into the policy in excess of this limit will result in reclassification of the policy as an MEC. However, the unused cap space within this limit is cumulative. For example, if the MEC limit for a policy is $5,784 the first year and $4,000 of the premium is paid into the policy, then the excess $1,784 of the unpaid premium is carried over to the premium limit for the second year.

This limitation expires after seven years, as long as no material changes, such as an increase in death benefit, occur. Any material change will effectively restart the seven-year test. A decrease in the death benefit will not restart the test, but it may result in the policy being immediately classified as an MEC in some cases.

Taxation of MECs

Any loans or withdrawals from an MEC are taxed on a last-in-first-out basis (LIFO) instead of FIFO. Therefore, any taxable gain that comes out of the contract is reported before the nontaxable return of principal. Furthermore, policy owners under the age of 59.5 must pay a 10% penalty for early withdrawal. It should also be noted that the IRS has its own set of guideline premiums that must be met in order for cash value policies to retain their FIFO status.

These standards apply to both flexible and single premiums and supersede those of the seven-pay test. For any given flexible-premium policy, the IRS has a single-premium limit that the cumulative annual premium payments may not exceed. For example, the IRS may assign a five-year single-premium limit of $24,000 to a policy.

If the annual MEC limit is $5,000, then the policy owner will exceed the $24,000 limit in the fifth year of the policy. Therefore the owner can only contribute $4,000 that year to avoid MEC status. They must then wait until the IRS guideline annual premiums catch up with their total premium payments in a later year. The consequences of exceeding the IRS guideline premiums are very severe; any policy that receives premium above this threshold will lose all of the traditional tax benefits accorded to life insurance policies. Life insurance companies will typically disallow any premium payment that exceeds the IRS guidelines for this reason.

Proper Use of MECs

Despite the reduced tax benefit and other limitations of MECs, they are often marketed as a stable retirement planning tool. They are usually touted as an alternative to annuities, which immediately become taxable upon the death of the owner. But MECs still resemble life insurance policies in that they pass their assets tax-free to heirs. These vehicles can be appropriate for investors looking for a way to leave a tax-free inheritance to their family members. However, the owner should not purchase an MEC with the intention of accessing the cash before the allowed time period, although emergency withdrawals are generally permissible.

The Bottom Line

Of course, most policy owners have no idea these guidelines exist. Policy owners who are concerned about whether their policy may become an MEC should consult their insurance agent or carrier to see what their policy is for handling excess premiums that would turn the policy into an MEC. Insurance carriers keep track of this matter and will notify their policy owners if either the seven-pay test or the IRS guideline premiums are exceeded. For more information on MECs and their proper use, consult your insurance agent or financial advisor.