Modified Endowment Contract (MEC)

Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

When does a life insurance policy cease to be one (and thus forfeit any tax benefits for the beneficiaries)? The answer is a modified endowment contract (MEC). This lesson will define an MEC and explain the tax implications of such contracts.

What is a Modified Endowment Contract?

A modified endowment contract (MEC) is a tax stipulation on a life insurance policy where the policy was funded with more money than federal law permits. According to US law, a modified endowment contract must meet certain requirements. The policy must:

  • Be entered on or after June 21, 1988
  • Be considered a life insurance policy
  • Fail to meet the 7-pay test

7-Pay Test

The 7-pay test is met if the total amount of premiums paid on a life insurance policy within the first seven years exceeds the premiums required to have the policy paid for seven years.

MEC 7-pay test

To give an example, consider the following table highlighting a hypothetical insurance policy. This policy has an annual premium of $3,750. After seven years, the cumulative premium would be $26,250.

Annual Premium Year Cumulative Premium
$3,750 1 $3,750
$3,750 2 $7,500
$3,750 3 $11,250
$3,750 4 $15,000
$3,750 5 $18,750
$3,750 6 $22,500
$3,750 7 $26,250

If this policy was underwritten after June 21, 1988, and is a valid life insurance instrument, it would be converted to an MEC if an extra payment was made in any of the years.

Tax Implications

Cash value life insurance is insurance that not only provides a death benefit but a cash value that can grow over time. For many years, you could withdraw interest or principal as part of a tax-free loan. This had the effect of people using life insurance as a tax shelter.

In 1988, Congress changed the rule by creating the MEC concept. The idea of capping the premium limit ensured that consumers were not overfunding their insurance policies as a means to build up their tax shelters.

When a withdrawal or loan is taken from an MEC, it is taxed on a last-in-first-out (LIFO) method. This means that taxable gains from the withdrawal or loan are assessed before any non-taxable return from the principal.

IRS Rules

For policies that have flexible premiums, the IRS has set its own rules. These always take precedence over the 7-pay test. For these types of policies, the IRS has set single-premium limits that annual payments can't exceed. From our previous example, the IRS may have set a five-year limit of $20,000. If the annual MEC limit is $3,500, we will exceed the limit by the fifth year and need to adjust contributions accordingly.

Also, the IRS is not nice if you don't follow the rules. Once the rule has been broken, you will lose all tax benefits normally granted to life insurance policies!

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