What is a Modified Endowment Contract?
A modified endowment contract (MEC) is a life insurance policy that has failed the seven-pay test and, consequently, has a cash value component that loses certain preferential tax treatments in the eyes of the IRS.
How life insurance becomes an MEC
No one buys an MEC at the outset. Instead, any life insurance policy with a cash value component (i.e., most permanent life insurance policies) can be classified as an MEC if certain things happen.
Specifically, the IRS can reclassify life insurance policies bought after June 1988 as MECs if they fail the seven-pay test, which was laid out in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This test is designed to identify policies that policy owners are using to avoid capital gains taxes.
So, what is the seven-pay test? It essentially says that if, over the course of the first seven years of the policy, you pay more in premiums than would be required to pay up the policy, your life insurance can be classified as an MEC.
This isn’t an issue for most people. The vast majority of indvidiauls who buy life insurance pay the minimum-required premium, which means their cash value component grows at a relatively slow rate. Even if you pay a little extra here or there with, say, a universal life insurance policy, you’re probably not going to need to worry.
People who might be subject to the MEC legislation are those who seek to use their life insurance policy as a tax shelter. The thinking goes that by paying a large amount over their required premiums, the cash value within the policy grows rapidly. Then, they have access to a large sum of money to use with preferential tax treatment.
At least, that was the case prior to TAMRA. Now, though, if you pay too much in premiums in the first seven years of your policy, it can get relabeled as an MEC. And that means losing certain tax benefitis.
Tax benefits of non-MEC life insurance cash value
If your life insurance policy isn’t an MEC, the money that accumulates in your life insurance policy’s cash value gets treated as a return of premium, not an investment gain. That means you can use it as collateral for a loan or you can get it paid to you in the event of a policy surrender without facing income taxes on it — provided your life insurance policy is not classified as an MEC.
What an MEC means
An MEC doesn’t change the tax treatment of your death benefit; your beneficiaries can still claim that money without paying income taxes on it. But if you take any distributions from your cash value, any earnings you withdraw could get taxed. Additionally, you may have a 10% penalty to pay if you’re younger than 59 ½.