Modified Endowment Contract Guide: Pros, Cons, and More

A Modified Endowment Contract (MEC) is a type of life insurance policy that can be modified to increase its cash value, but it comes with some trade-offs.

A MEC can be created by paying more premiums than the policy's maximum allowed, which is typically 7 times the policy's face value.

This can be a good option for those who want to increase their policy's cash value, but it's essential to understand the implications.

The IRS considers a MEC to be a Modified Endowment Contract, which means it's subject to certain tax penalties if the policy is surrendered or loans are taken against it.

A Modified Endowment Contract (MEC) is a cash-value life insurance policy whose cumulative premiums have exceeded the amount allowed under U.S. federal tax law limits.

The MEC came into being in the late 1980s, when the IRS moved to close a tax loophole involving permanent life policies. The IRS shut down that tax shelter strategy by enacting the Technical and Miscellaneous Revenue Act of 1988, also known TAMRA.

To be considered a MEC, a policy must meet the requirements of IRS Section 7702 and fail the 7-pay test outlined in TAMRA. This test is applied annually for the first seven years of a flexible-premium policy's existence.

Only life insurance policies that accrue cash value and were entered into after June 20, 1988 are subject to TAMRA and the MEC test. This includes variable life, whole life, and universal life policies, but excludes term life and single-premium whole life policies.

Cash value policies that fail the 7-pay test are immediately recognized as MECs and are subject to more restrictive tax rules. These rules discourage the intentional overfunding of life insurance to maximize tax-free earnings growth.

A modified endowment contract (MEC) is a type of life insurance policy that has exceeded the tax limits set by the IRS.

To be considered a MEC, your policy must have been secured on or after June 20, 1988. This is a key date to keep in mind if you're considering purchasing a life insurance policy.

A policy fails the "seven-pay test", which considers how much you've paid into a policy within the first seven years. If you've paid more than what's required to fully fund the policy during this time, you fail the test.

The seven-pay test is a crucial factor in determining whether your policy is a MEC or not. If you fail the test, your policy will be considered a MEC for the remainder of the time your contract is in force.

Here are the key criteria for a policy to be considered a MEC:

These are the basic requirements for a policy to be classified as a MEC. If your policy meets these criteria, you'll need to be aware of the more restrictive tax rules that apply to MECs.

A Modified Endowment Contract (MEC) can be a bit of a mixed bag. On the one hand, it still provides tax-deferred growth, so if you don't plan on withdrawing from your policy, you can build a large cash balance on a tax-deferred basis.

However, it's worth noting that MECs don't provide the same tax advantages as a standard life insurance contract, and most people might be better off avoiding them.

MECs still offer some benefits, including tax-deferred growth and a tax-free death benefit.

An MEC still provides some benefits, even if they aren't as appealing as standard life insurance contracts. One advantage is that MECs allow you to build a large cash balance on a tax-deferred basis, which can be beneficial if you don't plan on withdrawing from your policy.

The tax-deferred growth of an MEC means you won't have to pay taxes on the gains until you withdraw the funds.

Here are some specific advantages of MECs:

This means you can keep your life insurance policy and enjoy the tax benefits associated with it, even if it's an MEC.

Withdrawals from a Money Market Equity (MEC) come with some restrictions.

Withdrawals come first from gains and then from your principal, which means you'll be tapping into your initial investment if you've made some gains.

The taxable portion of any withdrawals taken before you turn 59½ are subject to an additional 10% early withdrawal penalty, which can be a significant added expense.

Loans are treated the same as withdrawals for tax purposes, meaning any gains come out first and are included in your taxable income.

Here are some key withdrawal rules to keep in mind:

A Modified Endowment Contract (MEC) is taxed differently than a standard life insurance policy. You'll pay taxes on withdrawals from an MEC, and these taxes can be significant.

Withdrawals from an MEC come first from your earnings, and then your principal. The earnings are included in your taxable income, and you'll also face a 10% early withdrawal penalty if you're under 59½ years old.

Loans and withdrawals from an MEC are taxed using last-in, first-out (LIFO) accounting. This means that you'll owe taxes on loans and withdrawals until you use up all of the earnings in the contract.

If you own more than one MEC purchased from the same company in the same year, the policies will be aggregated for purposes of determining the amount that is taxable.

Here are some key tax implications of a MEC:

It's worth noting that a MEC is subject to LIFO taxation on all gains that are classified as regular income. However, the cost basis of the policy and withdrawals are not subject to taxation.

Withdrawals from a MEC can be complex, and it's essential to understand the tax implications before making any decisions.

Cash value life insurance policies can become modified endowment contracts if you overpay in premiums. This can happen if you exceed federal contribution caps, which vary by insurance company and the IRS has its own limitations set.

You can withdraw from your cash value tax-free, but if you exceed these caps, this benefit is retracted. Typically, you can withdraw from your cash value without penalty until age 59 ½, but this can change if your policy becomes a modified endowment contract.

An overfunded life insurance policy may become an MEC only during the first seven years of the life of the policy. After the seventh-year mark, an overfunded policy may risk receiving MEC status only if you make changes to the policy's benefits.

If your policy becomes a modified endowment contract, its status can't be reversed. You'll most likely be contacted by your insurer if your policy becomes overfunded and is at risk of receiving MEC status.

Here's a summary of the key differences between a cash value life insurance policy and a modified endowment contract:

Cash in an MEC is easily accessible and can be withdrawn or borrowed at any time. Despite the tax consequences of the withdrawals, MEC funds are more liquid than, say, money invested in real estate, businesses, and even mutual funds.

Modified endowment contracts have tax rules similar to retirement annuities, which guarantee monthly or annual payments for life and can supplement Social Security.

These products overlap on some tax regulations, including penalties for early withdrawals.

A modified endowment contract retains a tax-free death benefit payout for beneficiaries, unlike retirement annuities.

The IRS defines a life insurance policy as a modified endowment contract if it meets certain criteria.

Here are the key factors that determine if a life insurance policy is a modified endowment contract:

Withdrawals from a Modified Endowment Contract (MEC) are taxed differently than life insurance policies. Unlike a standard life insurance contract, money you withdraw from an MEC comes first from your earnings and then your principal, and these earnings are included in your taxable income.

If you aren't at least 59½ years old, withdrawn earnings are also subject to an additional 10% early withdrawal penalty. This penalty applies to withdrawals from a MEC, but not from a traditional life insurance policy.

Withdrawals are considered taxable distributions, and the IRS takes a broad view of what constitutes a cash distribution. This includes withdrawals, loans, and cash dividends from MECs.

Here's a key difference between FIFO (first-in-first-out) and LIFO (last-in-first-out) taxation: under LIFO, cash value distributions are considered to be gains first and premiums last. This means the MEC owner will owe taxes on any distributions to the extent the cash value has grown.

The tax implications of a MEC can be complex, but it's essential to understand how they work to make informed decisions about your policy.

With a modified endowment contract, you'll face some penalties and consequences if you withdraw money too early. The earnings from your MEC are taxable as ordinary income before you turn 59 ½, and you'll also incur a 10% penalty.

This penalty is a significant one, and it's a major reason why it's generally not recommended to withdraw from an MEC before age 59 ½. After age 59 ½, you'll still face taxes on withdrawals, but the 10% penalty goes away.

Here's a breakdown of the tax implications of withdrawing from a MEC:

Withdrawals from a MEC come first from your earnings and then your principal, and the gains are included in your taxable income. This means that if you withdraw $10,000 from a MEC, the first $5,000 is the growth and is included in your taxable income.

Some policies may be exempt from the MEC rules, such as contracts issued before 1988. These older policies are not subject to the same MEC rules as newer policies.

A MEC may be created if a policy has a cash value of $2,000 or more at any point during the first two years. This is often referred to as a "MEC event."

Some policies may not be eligible for a MEC, such as those issued to pay for funeral expenses. These policies are not considered to be "life insurance" policies.

A policy may be converted to a MEC if it has a cash value of $2,000 or more and the policyholder has made a withdrawal of more than $2,000 from the policy's cash value.