A Modified Endowment Contract (MEC) is a type of life insurance policy that has lost some of its favorable tax treatment because it was overfunded, or funded too quickly, in its early years. Specifically, a policy becomes an MEC if it fails the IRS’s 7-pay test, which limits the cumulative premiums paid into the policy during the first seven years to an amount that would have fully paid up the policy’s death benefit within that period.
Why Do MECs Exist?
Congress introduced MEC rules in 1988 with the Technical and Miscellaneous Revenue Act (TAMRA) to prevent life insurance policies from being used primarily as tax shelters rather than as protection tools. Before MEC rules, policyowners could make large lump-sum payments into a policy and access cash value withdrawals or loans tax-free, sidestepping normal tax regulations applicable to investment products.
Understanding the 7-Pay Test
The 7-pay test sets a maximum limit on the total premiums that can be paid into a life insurance policy over its first seven years without turning it into an MEC. If at any point cumulative premiums exceed this limit, the policy is reclassified permanently as an MEC. This test is recalculated if there’s a significant change to the policy, such as adjusting the death benefit, and a new 7-pay period begins.
Tax Implications of MEC Status
The main tax differences between an MEC and a traditional (non-MEC) life insurance policy involve how cash value withdrawals and loans are treated:
- Withdrawals and Loans: For non-MEC policies, withdrawals are generally tax-free up to the cost basis, and loans are typically tax-free. For MECs, withdrawals and loans are taxed on gains first (using a Last-In, First-Out method), and early distributions (prior to age 59½) may incur an additional 10% tax penalty.
- Cash Value Growth: Continues to grow tax-deferred in both MEC and non-MEC policies.
- Death Benefit: Remains income tax-free to beneficiaries in both cases.
How a Policy Becomes an MEC
Common ways a policy becomes an MEC include:
- Paying a large lump sum premium exceeding the 7-pay limit.
- Making premium payments too quickly or in amounts that exceed the 7-pay limits.
- Significant policy changes, like lowering the death benefit without adjusting cash value appropriately.
Who Should Care About MEC Rules
Owners of cash value life insurance policies such as whole life, universal life, and variable universal life should understand MEC rules. Particularly relevant to those considering:
- Making large lump-sum payments.
- Drastically changing premium payments.
- Adjusting death benefits or policy riders.
Consulting with a knowledgeable insurance professional or financial advisor is critical to avoid unintended MEC classification.
Managing an MEC Policy
If your policy becomes an MEC:
- The death benefit remains tax-free.
- Cash value grows tax-deferred.
- Withdrawals and loans are taxed on gains first.
- Early withdrawals may incur a 10% penalty.
Planning to leave the policy intact and avoid distributions before age 59½ can mitigate tax impacts.
Frequently Asked Questions
Is an MEC still life insurance? Yes, MECs remain life insurance policies with tax-free death benefits.
Can I accidentally create an MEC? Yes, overfunding or certain policy changes can trigger MEC status.
Does term life insurance become an MEC? No, term life insurance has no cash value component and cannot become an MEC.
Are loans from MEC policies taxable? Yes, loans are treated as taxable distributions to the extent of gain and may incur penalties if taken before age 59½.
Sources
- IRS Publication 525 (Taxable and Nontaxable Income)
- Technical and Miscellaneous Revenue Act of 1988 (TAMRA)
- IRS Life Insurance Taxation Guidelines (https://www.irs.gov/individuals/life-insurance-tax-rules)
For more details on life insurance tax rules, visit the IRS Life Insurance Tax Rules page.