What is Modified Endowment Contract (MEC)?

Thang Truong
Thang Truong
Updated on:

What is a Modified Endowment Contract?

A modified endowment contract (MEC) allows you to leave a larger tax-free amount of money to your heirs with no additional costs. If you have no plans to use your life insurance money while still alive, ie. withdrawing from the cash value of your permanent life insurance policy, and instead are thinking of leaving it all to your heirs, you should consider a modified endowment contract. 

A modified endowment contract is originally a life insurance policy that has exceeded the federal tax law limits, so the IRS no longer considers it a life insurance policy anymore. Instead, they call it a modified endowment contract, or MEC. The IRS does this to prevent people from investing in life insurance as a way to avoid taxes. 

There are many types of life insurance policies, MEC usually applies to whole life, indexed universal life, and variable universal life policy only.

History of Modified Endowment Contract (MEC)

The unique advantage of cash value life insurance such as whole life, indexed universal life, or variable universal over other investment products is that they grow cash value account through investments, tax-deferred, and when you need to withdraw or loan money from the cash account of the policy, it is completely tax-free. This means that all investment gain are tax-free. As you can imagine, this is such a lucrative advantage, especially for the rich, they can abuse it. And they did, until the IRS introduced Modified Endowment Contract or MEC in 1988.

In the 1970’s and early 80’s, interest rates were at all-time high, approaching 20%. If you had money to invest, you could either invest in the stock market, buy government bonds, or you could buy a permanent life insurance policy. You’d have to qualify for it, but a permanent life-insurance policy offered tax-free growth, tax-free death benefits, and you could borrow against the policy, tax-free. With the interest rates being as high as they were, you could accumulate cash-value at a rate of 10% or more and enjoy tax-free on the interests you earn.

People could buy a single-premium permanent life insurance policy; that is, paying for a policy upfront. If you bought a $100,000 life insurance policy, it meant that wealthy people could park their money in a tax-free shelter and earn interest on the principal. The rates were competitive with other investments, except other investments were taxable. 

Thanks to flexible premiums, you could even pay more in premiums than the policy was actually worth, giving you a tax-free place to put your money. And if you wanted some of it back, you could borrow against it, tax-free. 

Naturally, the IRS found this objectionable and created laws to stop this practice. In 1988 they passed the Technical and Miscellaneous Revenue Act

How does the IRS Determine if My Life Insurance is an Modified Endowment Contract or an MEC?

If you have a term life insurance policy, you don’t have to worry about it. Only cash value life insurance such as whole life, universal life, indexed or variable life policies can become MEC’s. 

Certain criteria automatically make a life insurance policy an MEC. 

  • Any single premium policy is automatically an MEC
  • Any policy that fails the 7-pay test

Any policy issued before June 20, 1988 is exempt from these considerations. 

What is the 7-Pay Premium Test?

This limits the amount of money you can pay in premiums on the policy. The total amount you can pay in premiums over the first seven years of the policy. This is to prevent people from putting large amounts of money into small life insurance policies, as they did in the 1980’s. 

For example, if you have a policy worth $100,000 and your premiums are $1,000 a year, the total amount of premiums would be $7,000. If you pay more than that, the IRS will consider your policy to be an MEC. It’s cumulative over the first seven years. So, if you pay $2,000 in premiums one year, you can pay $500 the next two years and you will not create an MEC.

Your insurance company will usually tell you if you’re in danger of triggering MEC status. If you’re in danger, they will allow you to withdraw the excess premiums you paid. However, you should also pay attention to your premiums. Don’t be afraid to call your agent and ask if you have questions. 

If you make any changes to your policy, such as increasing the face value, the seven year test is restarted. 

You can decrease the face value of a policy but be careful that you haven’t overpaid your premiums. If you’ve been paying on a higher policy limit and then decrease the face value, the 7-pay test will be applied to the last seven years at the new rate. This could trigger MEC status.

Taxes on Modified Endowment Contract (MEC)

Once a life insurance policy becomes an MEC, it stays an MEC forever. You can’t go back and make it a life insurance policy. 

Once a policy becomes an MEC, any amount of money you withdraw is fully taxable as regular income. 

Much like an IRA account, any withdrawal you make from an MEC before you turned 59 and a half will be subject to a 10% penalty. The death benefit is still tax-free. 

Who Would Benefit from an MEC?

People who want to leave a large sum of money to their heirs tax-free should consider an MEC. You’re not going to be withdrawing or borrowing from the policy, so you shouldn’t have to worry about taxes on the loans. The only problem would be if your circumstances change and you’re in need of cash. 

An MEC is really an estate planning tool. If you have a lot of liquid assets sitting around, putting the money in an MEC makes it free from probate after you die, so your heirs can use it right away. 

Another advantage of an MEC is that the money is not counted in the Financial Aid Formula when applying for college. So, if you have children and are hoping to qualify for financial aid, the money you have in an MEC won’t be considered as an asset. 

If you were planning to tap into your life insurance when you retire, however, you need to make sure that your life insurance can never become a MEC, it must be a non-MEC. Any licensed life insurance agents can advise you on this topic and help you ensure that.

Last Thoughts

An MEC is a good tool for those wanting to leave their heirs a substantial tax-free death benefit and don’t plan on withdrawing any cash from the account. Most insurance companies will keep track of policies and let you know if your policy is in danger of becoming an MEC if that’s not what you want. As with any financial investment, it all depends on how you want to use it. 

Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at realtor.com, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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