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What Is a Modified Endowment Contract?

Mar 07, 2021 4 min read Riley Adams

Key takeaways

  • A modified endowment contract (MEC) is a cash value life insurance policy that gets stripped of many tax benefits.
  • The seven-pay test determines if the policy qualifies as an MEC.
  • MECs ended a popular way to shelter money from taxes by borrowing from insurance policies whose cash value grew too quickly.

 

While all life insurance policies can provide a tax-advantaged way to transfer money to your heirs, one of the biggest advantages of permanent life insurance comes from the death benefit, as well as the tax-free growth of the policy's cash value: A portion of your money can grow over time in investments for when you might need it down the road. This money carries tax advantages because it's treated as a return of premium (your payments) instead of investment gains.

Even so, you should be careful about paying too quickly into a cash value insurance policy: If you pay too much too fast, the IRS can decide to change the policy into a modified endowment contract.

 

 

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:

  1. You purchased the policy on or after June 20, 1988.
  2. The MEC meets the definition of a life insurance policy.
  3. 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.

 

The pros and cons of an MEC

Despite losing some of the tax benefits of a cash value life insurance policy, MECs can still have a positive impact on your financial planning. For example, MECs can function as an alternative or supplement to annuities in your retirement and estate planning.

Like annuities, you can withdraw money in retirement with the earnings treated as ordinary income. But because MECs are life insurance products, they also allow you to leave a tax-free inheritance to your loved ones. Annuities, on the other hand, become taxable when you die.

Also, as with an annuity, withdrawing from an MEC before you turn 59½ will trigger a 10% penalty. Therefore, if you expect to tap into your funds before retirement, an MEC might not serve you well.

 

What are the tax implications for an MEC?

When your life insurance policy gets turned into an MEC, its tax treatment changes. Your withdrawals from the policy are treated like a nonqualified annuity Opens in new window.

Like nonqualified annuities, MECs act as investment products that are funded with after-tax dollars. When you take money out of an MEC, you only need to pay taxes on the earnings you receive. The IRS treats this money as ordinary income.

 

What you can do next

While MECs offer benefits to some policyholders, they may not suit everyone's goals. If you're considering converting an insurance policy to an MEC (by renewing an old policy or overpaying premiums), speak with a financial professional to determine where it might fit into your financial plan.

Footnotes

Riley Adams is a senior financial analyst at Google with over a decade of professional experience. He has written for MarketWatch, Kiplinger, MSN, Yahoo Finance, Morningstar and TDAmeritrade, as well as his own personal finance website.

 

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