Here are a few things to know about modified endowment contracts.
What is a modified endowment contract?
A modified endowment contract (MEC) is a designation given to cash value life insurance contracts that have exceeded legal tax limits.
When the IRS relabels your life insurance policy as an MEC, it removes the tax benefits of withdrawals you can make from the policy. You can lose these benefits if you pay too much in premiums in too short a period of time.
In the 1970s, many insurers tried to take advantage of the tax-free growth of cash value policies. They did so by offering life insurance products with substantial cash value growth features. When policyholders needed to access this cash value, they could tap the principal and interest of an active policy as a tax-free loan.
This effectively allowed them to access significant tax-sheltered assets, and the government quickly caught on. In response, they introduced the MEC to counteract these limitless benefits.
For a life insurance policy to change into an MEC, it must meet three criteria:
- You purchased the policy on or after June 20, 1988.
- The MEC meets the definition of a life insurance policy.
- The policy fails the "seven-pay" test.
What is the "seven-pay" test?
The seven-pay test helps the IRS determine whether your life insurance policy will be converted into an MEC. It compares the total premiums you paid in the first seven years of the policy with what you'd need to pay it in full. If your payments exceed what's needed, your policy becomes recognized as an MEC.
If you purchased a life insurance policy before June 20, 1988, it isn't subject to these premium limits. But you should be aware of renewing a policy bought before this time, as it could face the seven-pay test.