What Is a Modified Endowment Contract?
A modified endowment contract (MEC) is a tax qualification of a life insurance policy whose funding exceeds federal tax law limits. The taxation structure and IRS policy classification permanently change after a life insurance policy morphs into a modified endowment contract.
Permanent life insurance contracts are granted generous tax advantages in the U.S., but if you put too much cash inside of a policy, it loses its status as "insurance" and becomes an investment vehicle instead. In other words, it no longer is treated as a life insurance policy, but as a MEC. The MEC limits for a policy will depend on its terms and death benefit amount. Your insurance company will warn you if a policy is about to become, or has become a MEC.
- A modified endowment contract (MEC) is the term given to a life insurance policy whose funding has exceeded federal tax law limits.
- These limits on the amount of cash inside a policy are in place to avoid abusing tax advantages inherent in permanent life insurance.
- The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) seven-pay test.
- The taxation of withdrawals under the MEC is similar to that of non-qualified annuity withdrawals.
- Once a policy has triggered MEC status, it cannot be reversed.
Avoiding The Modified Endowment Contract Trap
Understanding Modified Endowment Contracts
A modified endowment contract (MEC) happens when the IRS no longer recognizes a policy as a life insurance contract, because the total collected premiums exceed federal tax law limits. This classification seeks to combat calling something "life insurance" to avoid taxes.
Specifically, 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 must meet the statutory definition of a life insurance policy.
- The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.
The seven-pay test determines whether the total amount of premiums paid into a life insurance policy, within the first seven years, is more than what was required to have the policy considered paid up in seven years. Policies become MECs when the premiums paid to the policy are more than what was needed to be paid within that seven-year time frame.
Life insurance policies entered into before June 20, 1988, are not subject to the payment of premiums over the money allowed under federal laws. However, the renewal of an older life insurance policy after this date is considered new and must be subjected to the seven-pay test.
The IRS requires a life insurance policy to comply with a strict set of criteria in order to avoid becoming a MEC.
Tax Implications of a MEC
The taxation of withdrawals under the MEC is similar to that of non-qualified annuity withdrawals. For withdrawals before the age of 59 1/2, a premature withdrawal penalty of 10% may apply. As with traditional life insurance policies, MEC death benefits are not subject to taxation. Modified endowment contracts are usually purchased by individuals who are interested in tax-sheltered, investment-rich policies, and do not intend to make pre-death policy withdrawals.
Unlike traditional life insurance policies, taxes on gains are regular income for MEC withdrawals under last-in-first-out (LIFO) accounting methodology. However, the cost basis within the MEC and withdrawals is not subject to taxation. The tax-free death benefit makes MECs useful for estate planning purposes, provided the estate can meet the qualifying criteria. Furthermore, policy owners who do not take withdrawals can pass on a significant sum of money to their beneficiaries.
Pros and Cons of MECs
In general, a MEC is undesirable for the owner of a life insurance policy. A MEC will see many of the tax advantages of life insurance disappear, and the money inside the MEC will become far less accessible than in a life insurance policy.
That said, some individuals may benefit from purchasing a MEC (not for life insurance) because it often offers a higher yield on effectively riskless money (i.e., more than savings accounts or CDs), and allows for the transfer of assets to beneficiaries tax-free and without probate upon the owner's death.
Another downside is that if a MEC even is triggered, it cannot be undone.
How Are Taxes on Gains Figured in a MEC?
Taxes on gains are regular income for MEC withdrawals under last-in-first-out accounting methodology. However, the cost basis within the MEC and withdrawals is not subject to taxation.
What Triggers a MEC?
A MEC is triggered if the amount of cash inside a permanent life insurance policy exceeds legal limits to be classified as insurance. This limit is set a certain amount below the amount of the policy's death benefit (known as the corridor). The IRS uses a heuristic test to determine MEC status. The seven-pay test looks at if the premiums paid during the first seven years of the policy would exceed the amount for the policy to be paid up after seven years.
How Can You Avoid MEC Status?
A life insurance policy can avoid triggering MEC status so long as the amount of cash inside the policy remains beneath the required corridor below the death benefit. If you use a policy to accumulate cash value, one solution is to increase the death benefit through paid-up additions (PUA), which raises the corridor's ceiling.
What Are the Likely Tax Consequences of an Early Withdrawal Under a MEC?
Withdrawals are taxed similarly to those of a non-qualified annuity. For withdrawals before the age of 59½, a penalty of 10% may apply. As with traditional life insurance policies, MEC death benefits aren't subject to taxation.
Is a Modified Endowment Contract a Good Thing?
Generally speaking, converting a life insurance policy to a MEC is not a good thing. This is because the MEC loses many of its prior tax advantages that were in place when it was classified as life insurance. That said, purposefully creating a MEC can be an estate planning tool under certain circumstances.