A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax advantages because it accumulates too much cash. When the Internal Revenue Service (IRS) classifies a life insurance policy as an MEC, the policy loses tax benefits linked to withdrawals and loans. This shift occurs if you pay significantly high premiums over a brief period.
Permanent life insurance policies are typically offered generous tax benefits in the United States. However, exceeding the cash value limits converts the policy from insurance to an investment vehicle. MEC status depends on the policy’s terms and death benefit amount. Insurance companies are required to notify you if your policy approaches or attains MEC status.
Key Takeaways
- A Modified Endowment Contract (MEC) refers to cash value life insurance that loses its tax advantages due to excessive cash value.
- IRS imposes cash value limits to prevent the exploitation of tax benefits associated with permanent life insurance.
- To classify as an MEC, a life insurance policy must fail the “seven-pay test” as per IRS guidelines.
- Withdrawals from a MEC are taxed and possibly penalized, akin to non-qualified annuities.
- MECs might still appeal to some due to higher yields compared to savings accounts and ease of asset transfer post-death.
Understanding Modified Endowment Contracts (MECs)
An MEC arises when the IRS no longer acknowledges a policy as life insurance due to excess collected premiums and cash value surpassing federal limits. This designation combats the misuse of life insurance as a tax shelter. In 1988, U.S. legislation limited how insurance policies amass cash value tax-free.
Some policyholders, often high-net-worth individuals, might deliberately overfund their policy and use it as an investment by taking loans against it. This approach diminishes the death benefit for heirs but might be appealing if certain conditions like retirement security or grown-up children are met.
Criteria for an MEC, Including the Seven-Pay Test
A life insurance policy is categorized as an MEC if it meets three criteria:
- Initiated on or after June 20, 1988.
- Meets the legal definition of a life insurance policy.
- Fails to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) seven-pay test.
The seven-pay test dictates that the premiums paid during the first seven years must not surpass the amount needed for the policy to be fully paid up in those years. Policies formulated before June 20, 1988, are exempt unless renewed post this date and must meet the seven-pay test requirements.
Using a Paid-Up Additional (PUA) Rider to Avoid MEC
To avoid MEC status, ensure the cash within the policy stays below a specified margin relative to the death benefit (the corridor). Adding a Paid-Up Additional (PUA) insurance helps raise the ceiling by increasing the death benefit.
Tax Implications of an MEC
The cost basis within an MEC and withdrawals aren’t taxed. Gains, however, are taxed as regular income using the last-in-first-out (LIFO) methodology, making interest withdrawals taxed before principal.
Withdrawals before 59½ years may incur a 10% penalty, likened to non-qualified annuity withdrawals. Traditional policy loans in an MEC become taxable as withdrawals, subject to the 10% early withdrawal penalty if applicable, following the same LIFO rules.
Despite these drawbacks, death benefits from MECs are tax-free, making them strategic for estate planning without pre-death withdrawals.
Pros and Cons of MECs
Pros
- Higher Yield on Low-Risk Funds: Often offers higher yields on low-risk funds compared to savings accounts or CDs.
- Tax-Free Asset Transfer After Death: Allows for smooth transfer of assets tax-free upon the owner’s death.
- Can Be Borrowed Against: Cash value can still be borrowed against, though taxes apply to interest gains.
Cons
- Lost Tax Advantages: Withdrawals and loans are taxed and possibly penalized early—a disadvantage compared to non-MEC policies.
- Less Accessible Cash Value: Accessibility of funds is reduced due to potential taxes.
- Borrowing Reduces Death Benefit: Loans reduce the eventual benefit paid to heirs.
How Are Taxes on Gains Figured in an MEC?
Gain taxation follows the LIFO accounting approach, where interest is dispensed before principal. Premiums paid (cost basis) aren’t taxed but withdrawals above it are.
What Triggers an MEC?
An MEC is activated if the policy’s cash value breaches federal limits. The IRS seven-pay test considers whether initial premiums would fully pay the policy in its first seven years.
How to Avoid MEC Status?
Ensure accumulated cash remains below the mandated margin beneath the death benefit. Increasing the death benefit through PUAs can avert MEC status.
Tax Consequences of Early Withdrawals Under an MEC
Early withdrawals are taxed akin to non-qualified annuities, with a potential 10% penalty before age 59½. Death benefits remain tax-free.
Is a Modified Endowment Contract a Good Thing?
Generally, an MEC status is unfavorable due to the loss of tax advantages. However, deliberate MEC creation can be beneficial for specific estate planning endeavors.
The Bottom Line
An MEC is a cash value life insurance policy that loses significant tax benefits due to holding too much cash. Reclassified by the IRS, its withdrawals and loans are taxed; the change is permanent. Though typically disadvantageous, MECs may offer higher yields compared to many low-risk investments and facilitate post-death asset transfers.
Related Terms: seven-pay test, paid-up additional (PUA) insurance, life insurance, annuity.
References
- MassMutual Financial Group. “Modified Endowment Contracts Guide”, Page 2.
- U.S. Congress. “H.R.4333 - Technical and Miscellaneous Revenue Act of 1988”.
- Internal Revenue Service. “Revenue Ruling 2005-6”.
- Internal Revenue Service. “Revenue Procedure 2001-42”.
- Duplifund. “Modified Endowment Contract - ‘MEC”.’
- Thrivent. “What Is a Modified Endowment Contract, or MEC?”
- Indexed Universal Life. “Fifo to Lifo”.
- Northwestern Mutual. “What Is Cost Basis and How Do You Calculate It?”
