Although it’s been around for nearly 30 years, a MEC, or a modified endowment contract, can still be confusing. Let’s straighten it out. A modified endowment contract is a unique type of cash value life insurance. A life insurance policy becomes a MEC when the policy has been funded more than federal tax laws permit.
Upon changeover, a MEC loses some of the favorable tax treatment it had as cash value life insurance. For tax purposes it’s now treated like a non-qualified annuity. While the cash value does stay intact and grow tax-deferred, you will be taxed on the cash value growth upon taking withdrawals.
Depending on state laws, cash value withdrawals may be subject to state income tax, along with the federal income tax you must pay. If taken before age 59.5, an early withdrawal penalty of 10% may apply, as well.
Because of these potential tax implications, it’s important to understand MECs, their features, and their potential consequences. Here’s a look at a MEC and how it may affect a life insurance policy.
A Quick Breakdown of the MEC
A life insurance policy becomes a MEC when total premiums paid into it surpass the amounts permitted under the Internal Revenue Code. When a policy turns into a MEC, the IRS no longer considers it life insurance. Both single-premium and flexible-premium life insurance can change into a MEC. However, this doesn’t matter much for single-premium policies, as we will see later on.
In a MEC, only the tax status of the cash value changes. The death benefit, payable to beneficiaries, remains income tax-free. Because of this, many MEC purchases are for tax-sheltered money growth or tax-efficient legacy planning purposes. Much of the time, MEC buyers don’t have interest in pre-death withdrawals, as their cash value accumulation would incur income taxation.
Many single-premium policies are bought for tax-free leveraged legacy planning purposes. So a MEC qualification won’t affect policies used for that goal too much.
When Does Life Insurance Turn into a MEC?
A life policy becomes a MEC upon fulfilling three conditions:
- The policyholder entered into the policy on or after June 21, 1988.
- The policy meets the requirements of Section 7702 of the tax code, or where the statutory definition of life insurance is presented.
- The policy fails to meet the 7-pay test.
What about “grandfathered” policies, or life insurance policies entered into before June 21, 1988? They aren’t subject to premium payments in excess of the funding limits permitted under federal law. With that said, if a grandfathered policy were renewed after June 21, 1988, it would be subject to the 7-pay test.
What is the 7-Pay Test?
The 7-pay test is used to decide whether a life insurance policy qualifies as a MEC. In it, essentially a 7-year test is used, whereby an algorithm determines the appropriate ratio between the policy’s face amount and premium. The assessor looks at two things: the cumulative sum of premiums paid into the policy over the first 7 years, and the sum of premiums required for the policy to be paid up in a 7-year window.
If the total amount of premiums paid surpasses the amount required to be paid up, the policy is a MEC according to federal tax laws. At this point, the IRS doesn’t consider the policy to be bona fide life insurance anymore.
Why Was the MEC Created?
The concept of a modified endowment contract came about in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Prior to that, life insurance policies, with some exceptions, received “first in, first out” tax treatment. That meant that premiums paid into a policy were returned tax-free before income was recognized. Moreover, policy loans were free of taxation unless someone surrendered their life insurance contract.
The cost of insurance was so small, virtually all of the premium was growing tax-preferred. So, many Americans started using life insurance policies for tax sheltered investments — not for the death benefit. The federal government judged it to be an excessive use of life insurance tax advantages. It was deemed to be an inappropriate abuse of life insurance’s tax treatment. This situation also presented a potential harm to public revenue collections, hence why Congress moved into action.
So, the MEC was established to prevent astronomical amounts of premiums being dumped into a cash value life insurance policy solely designed for its tax advantages. Say someone inherited an extremely large sum of money and wanted to put it into a $40,000 death benefit life policy. Or say a high-earning executive wanted to stash $300,000 in premiums annually in a $50,000 death benefit life insurance policy.
While these are extreme examples, they show the wide gap between the premiums paid and the small face amount of the policy. When TAMRA passed in 1988, federal laws no longer permitted abnormally high ratios between face amount and premium. Hence the rules for MEC qualification arose then.
Can a MEC Change Back into a Life Insurance Policy?
In short, no. Once a policy is considered a MEC, it’s always a MEC. A policy can’t lose its MEC qualification even if you exchange the cash value for a new policy. The only way to obtain life insurance, once again, is to start a new one from scratch.
While MECs can be challenging to navigate, they can be a valuable addition in retirement planning strategies. Working with a knowledgeable financial professional can help you discern your goals, needs, objectives, and what, if any, strategies may be right for you.
Ready for Personal Guidance?
If you are ready for guidance with your financial future, financial professionals stand ready to help you.
Use our “Find a Financial Professional” section to connect with someone directly. And call us at 877.476.9723 if you need a personal referral.