Modified Endowment Contract (MEC)

What is the difference between a modified endowment contract and a traditional endowment contract?

A modified endowment contract (MEC) is a tax-qualified life insurance policy with premiums that exceed federal tax law limits. After a life insurance policy becomes a modified endowment contract, the taxation structure and IRS policy classification change.

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TAKEAWAYS IMPORTANT

• The phrase "modified endowment contract" (MEC) refers to a life insurance policy whose funding exceeds federal tax law limits.
• The policy must fail the seven-pay test established by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).
• Withdrawals under the MEC are taxed in the same way that non-qualified annuity withdrawals are.

The Modified Endowment Contract: An Overview (MEC)

The phrase "modified endowment contract" (MEC) refers to a life insurance policy whose funding exceeds federal tax law limits. To put it another way, the IRS no longer considers this to be a life insurance contract. The categorization modification was made to combat the usage of the "life insurance" category for tax evasion purposes.

The IRS considers a life insurance policy to be a MEC if it meets three requirements:

• On or after June 20, 1988, the policy is signed.
• It must be a life insurance policy as defined by the law.
• The policy must fail to pass the TAMRA (Technical and Miscellaneous Revenue Act of 1988) seven-pay test.

The seven-pay test analyzes if the total amount of premiums paid into a life insurance policy over the first seven years exceeds the amount required to consider the policy paid up after seven years. When premiums paid on a policy exceed the amount required to be paid during the seven-year time frame, the policy becomes a MEC.

Prior to June 20, 1988, life insurance policies were not subject to the payment of premiums in excess of the amount allowed by federal law. However, after this date, any renewal of an older life insurance policy is considered fresh and must pass the seven-pay test.

A MEC's Tax Implications

Withdrawals under the MEC are taxed in the same way that non-qualified annuity withdrawals are. A premature withdrawal penalty of 10% may apply to withdrawals made before the age of 59 1/2. MEC death payouts are tax-free, much like standard life insurance contracts. Individuals who want tax-sheltered, investment-rich policies but don't want to make pre-death policy withdrawals typically purchase modified endowment contracts.

Taxes on gains constitute regular income for MEC withdrawals under the last-in-first-out (LIFO) accounting system, unlike standard life insurance policies. The cost basis within the MEC, however, as well as withdrawals, are not taxed. MECs are important for estate planning because of the tax-free death benefit, providing the estate meets the qualifying criteria. In addition, policyholders who do not take withdrawals can leave a substantial sum to their beneficiaries.