Modified Endowment Contract

Modified Endowment Contract (MEC)

A modified endowment contract (MEC) is a permanent life insurance policy that has been overfunded relative to IRS limits, causing it to lose certain favorable tax treatments. The Internal Revenue Service determines MEC status primarily through the “seven‑pay test.” Once a policy is classified as an MEC, withdrawals and loans are taxed differently and may incur penalties, though the death benefit generally remains income‑tax free.

Key takeaways

• MECs result from paying too much into a cash‑value life insurance policy too quickly under IRS rules (the seven‑pay test).
• Withdrawals and loans from an MEC are taxed under last‑in, first‑out (LIFO) rules; earnings are treated as ordinary income first.
• Withdrawals (or loans treated as distributions) before age 59½ may be subject to a 10% penalty.
• The income tax exclusion for the death benefit usually remains intact.
• MECs can still be useful for estate planning or as a low‑risk yield vehicle, but they permanently forfeit many of the tax advantages of traditional life insurance.

How an MEC arises

The main rule that triggers MEC status is the seven‑pay test (part of the Technical and Miscellaneous Revenue Act of 1988). The test asks whether the total premiums paid during the first seven years of the policy exceed the amount that would have been required to fully pay up the policy under a level‑premium schedule. If premiums paid exceed that threshold, the policy becomes an MEC.

Additional points:
* Policies issued on or after June 20, 1988 are subject to these rules. Older policies can become subject if they are materially changed or effectively replaced after that date.
* MEC status is typically permanent for that contract and cannot be undone.

Tax treatment of MECs

• Cost basis: The total premiums you paid (your cost basis) are not taxed when withdrawn, but earnings above that basis are taxable.
• LIFO taxation: Withdrawals follow last‑in, first‑out order—gains are treated as distributed first and taxed as ordinary income.
• Penalties: Distributions of earnings taken before age 59½ may incur a 10% premature distribution penalty (similar to non‑qualified annuities).
• Loans: Policy loans from a traditional life policy are generally tax‑free; in an MEC, loans are taxed like withdrawals (earnings come out first and may be subject to the 10% penalty if before 59½).
• Death benefit: The income tax exclusion for the death benefit typically remains—beneficiaries receive the policy proceeds income‑tax free.

Ways to avoid MEC status

• Monitor premium pacing to ensure you do not exceed the seven‑pay threshold in the first seven years.
• Use paid‑up additional (PUA) riders or increase the death benefit to preserve the required corridor between cash value and death benefit. Increasing the death benefit raises the allowable cash value before the policy becomes an MEC.
• Be cautious when making large single premiums, taking back loans, or making material policy changes that could trigger a new seven‑pay test.

Pros and cons

Pros
* Potentially higher, relatively low‑risk yields compared with bank savings or short‑term CDs.
* Death benefit usually remains income‑tax free, useful for transferring wealth to beneficiaries without probate.
* Cash value remains accessible through distributions or loans (but with tax implications).

Cons
* Loss of favorable tax treatment for withdrawals and loans—earnings are taxed as ordinary income.
* Early distributions may incur a 10% penalty.
* Cash value becomes less accessible net of tax, and borrowing can reduce the death benefit payable to heirs.
* MEC status cannot be reversed for the contract.

Practical considerations

• MECs may be appropriate for investors who prioritize estate planning or prefer a conservative, tax‑efficient vehicle for transferring wealth and who do not plan to make taxable withdrawals during life.
• For those who expect to use the policy’s cash value while alive, triggering MEC status can be costly because of the change in tax treatment.
• Always run illustrations and consult a qualified insurance or tax professional before making large premium payments or policy design changes.

Frequently asked questions

Q: What exactly triggers MEC status?
A: Paying more premium into a permanent life insurance policy during the first seven years than is allowed under the seven‑pay test triggers MEC status.

Q: Can an MEC be converted back to a regular life insurance policy?
A: No. Once a contract is classified as an MEC, that status is generally permanent for that contract.

Q: Are death benefits from an MEC taxable?
A: Typically no. The death benefit remains income‑tax free to beneficiaries, subject to estate tax rules.

Q: What happens if I withdraw money from an MEC before age 59½?
A: Earnings withdrawn are taxed as ordinary income under LIFO rules and may be subject to an additional 10% penalty.

Bottom line

A modified endowment contract is a permanent life insurance policy that has been overfunded relative to IRS limits and therefore loses many favorable tax advantages for distributions and loans. While MECs still provide a tax‑free death benefit and can serve certain estate‑planning or low‑risk yield objectives, they impose less favorable tax treatment on living access to policy cash value. Carefully consider premium pacing and consult an insurance or tax professional before making funding decisions that could trigger MEC status.