A modified endowment contract (MEC) is a tax qualification of a life insurance policy whose cumulative premiums exceed federal tax law limits. The taxation structure and IRS policy classification changes after becoming a modified endowment policy.
The taxation of withdrawals under the MEC is similar to the 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.
Specifically, a life insurance policy is considered an MEC by the IRS if it meets three criteria. First, the policy is entered into on or after June 20, 1988. Second, it must meet the statutory definition of a life insurance policy. Third, the policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.
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, it is considered new and must be assessed with the 7-pay test.
The 7-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 an MEC when the premiums paid to the policy are more than what was needed to be paid within that 7-year time frame.
Unlike traditional life insurance policies, taxes on gains are regular income for MEC withdrawals under last-in, first-out (LIFO) accounting. 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. Furthermore, policy owners who do not take withdrawals can pass on a significant sum of money to their beneficiaries.