What is a Modified Endowment Contract ( MEC )?

A modified endowment contract (commonly referred to as a MEC) is a tax qualification of a life insurance policy that has been funded with more money than allowed under federal tax laws.  A life insurance policy that becomes a MEC is no longer considered life insurance by the IRS, but instead, it is considered a modified endowment contract.  Being considered a MEC changes the order of taxation within the contract for money withdrawn and may penalize the life insurance owner for withdrawals before age 59.5.  Essentially a life insurance contract that becomes a MEC is treated as a nonqualified annuity by the IRS for taxation purposes prior to the insured persons passing.  A death claim can still be tax-free even if the policy payout out the death claim is a MEC.

Modified Endowment Contract (MEC) Explained

modified endowment contract is a cash value life insurance contract in the United States where the premiums paid have exceeded the amount allowed to keep the full tax treatment of a cash value life insurance policy. In a modified endowment contract, distributions of cash value are taken from taxable gains first as compared to distributions taken from non taxable contributions. In other words, withdrawals will typically be taxed as ordinary income (typically the highest rates for investments) instead of treated as non taxable income.

History of Modified Endowment Contracts

In the late 1970s, many life insurance companies sought to leverage the tax-advantaged status of cash value life insurance contracts by creating products that facilitated substantial accumulation of cash value, which would then allow the policy owner to make sizeable tax-free withdrawals at any time.

But Congress viewed these vehicles as tax shelters and decided to place a limit on the amount of money that could be placed into a flexible premium cash value policy. Thus the “7 pay test” rule was born as one of the components of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).

This act, therefore, created the MEC. Before TAMRA was passed, all withdrawals from a cash value life insurance policy were taxed on a first-in-first-out (FIFO) basis, which meant that all withdrawals were considered to be a tax-free return of principal up to the amount of premiums that had been paid.

But the seven-pay test instituted by TAMRA set a limit on the amount of premiums that could be paid into a flexible premium cash value policy and still retain FIFO tax status on withdrawals.

Furthermore, the IRS also has its own set of tax laws that apply on a per-policy basis that outline the maximum amount of premium that can be paid into the policy for both single and flexible premium non-mec policies.

These limits are based on the amount of level premium that it would take to pay up the policy after seven years and supercede those of the 7-pay test codified in TAMRA. Any violation of the IRS limits results in the policy immediately being reclassified to MEC status under federal tax law. This is true for whole life insurance, variable life insurance and universal life insurance policies.

Any single premium cash value policy is now classified as an MEC policy, and most life insurance companies will not allow their policyholders to pay premiums that will violate the seven-pay test. All flexible premium cash value policies have both an annual and a cumulative dollar limit for each policy that is determined by the amount of death benefit and the age of the insured.

For example, the IRS might stipulate that the maximum amount of annual premium that can be paid into a newly-issued policy is $6,784, and the maximum amount of premium that can be paid into the policy over 7 years is $30,000. But any remaining difference between the annual limit and the actual amount of premium that is paid is then automatically applied towards the following year.

So if the policy owner paid $5,000 in premium into the policy this year, then the remaining $1,784 would be added to next year’s limit of $6,784 and thus raise that year’s limit to $8,568. But if the total premiums paid reach $30,000 within the seven year period, then only the minimum premium payment set by IRS guidelines can be paid until the end of the period.

Therefore the policy holder could not pay $6,784 of premiums every year for seven years, because this would obviously exceed the $30,000 limit. He could pay that amount every year until this limit is reached, and then pay the IRS guideline minimum required premiums for the remainder of the seven year period.

However, this limitation expires at the end of the seven year period, provided that no material changes have been made to the policy, such as an increase in the face amount or any additional riders or changes in the insureds on the policy. If any material change is made, then the seven-year test will be restarted.

A decrease in the death benefit is the one exception to this rule; a decrease will not automatically restart the seven year period, but it may result in the policy becoming reclassified as an MEC. This is because the seven-pay test will be reapplied to all cumulative premiums paid over the last seven years at the new lower limit, so it is possible that the policy can become an MEC due to premiums that were paid several years ago based on a higher death benefit.

In addition to reduction of the death benefit, other examples of reductions in benefits include cancellation of insurance policy, reduction in protection afforded by one or more riders attached to the policy or a lapse in the policy that is not reinstated within 90 days.

The Tax Benefits Of Life Insurance Contracts

Life insurance contracts are afforded special treatment under United States tax laws.  For instance, the death benefit is tax-free (even a MEC). Funded with after-tax dollars, the life insurance contract’s value will grow tax-deferred until the death of the insured, in which case the entire amount can be handed down free of any taxes to the next generation.  Any withdrawals taken from a life insurance contract are tax-free up to the total amount of the cost basis (the amount of money put into the policy) with the gain being considered the last part of the contract to be withdrawn for tax purposes (FIFO accounting).  These attractive tax benefits make whole life insurance a popular savings and estate planning vehicle for wealthy individuals.

What Type of Life Insurance Can Become a MEC?

Any permanent life insurance policy has the potential to become a modified endowment contract if it is “over-funded”.  This includes whole life, universal life, variable life, and variable universal life insurance.  A term life insurance policy can not become a MEC because there is not any cash surrender value and no incentive or the ability for an owner to pay in a high amount of premium dollars in order to take advantage of the tax breaks.  An important distinction to remember: A life insurance policy can not become a MEC from a high rate of return of the existing cash value.  It can only become a modified endowment contract from too many premium dollars being paid into the policy.

Tamra 7 Pay Test

As of June 21st of 1988, the federal government placed into effect the Technical and Miscellaneous Revenue Act (TAMRA), which placed limits on the amount of money that can be put into a life insurance contract during the first 7 years of the policy’s existence.  Because of the attractive tax features of a life insurance contract discussed above, prior to 1988 a small life insurance contract could be funded with a huge sum of money, grow tax-deferred, a large portion of the cash could be accessed tax-free for withdrawals, and the value passed on to the next generation free of taxes.  The small life insurance contracts had a small cost of insurance, and could still accumulate significant gain based on the dividend payments made into the policy by the insurance company (dividend payments grow larger as cash value is higher).  Tamra sought to end this tax loophole by limiting the amount of money dumped into a life insurance contract.

Effect Of TAMRA (How A MEC Is Taxed)

TAMRA limits were meant to slow this practice by now considering these overly funded life insurance contracts as modified endowment contracts.  Any contract issued after June 21, 1988, which is funded in excess of the 7 pay test limits will now be considered a MEC. TAMRA has significantly reduced the number of contracts that exceed the 7 pay funding limits.

Gain First (LIFO) Taxation

A MEC will have any gain taxed first on withdrawals (LIFO accounting), which is the opposite of a life insurance contract.  A whole life insurance policy that becomes a MEC will almost certainly accumulate significant gain fairly quickly due to dividend payments. Even policy loans will be taxed, so it becomes much more difficult to access cash within a MEC policy unless the owner is willing to face the tax consequences.  The cost basis of a modified endowment contract is still not taxed but will be considered to be the last money to come out of a MEC contract for tax purposes.  The gain is taxed as income at the owner’s marginal rate of income tax level.

Penalty On Withdrawals Before Age 59 1/2

Any withdrawal taken before age 59 1/2 is subject to a 10% tax penalty on the amount of any gain in most circumstances.  This is in line with nonqualified annuity taxation, and retirement account taxation.  The cost basis is not subject to a penalty just as it is not subject to taxation.  There may be some circumstances in which a withdrawal before age 59.5 is not penalized, such as the withdrawal being under a 72T provision, which allows substantially equal payments to be withdrawn from an annuity, retirement account, or modified endowment contract each year without penalty.  These must continue to be withdrawn until the greater of 5 years or age 59.5.  The consequences of breaking a 72T are significant, and at Life Ant, we advise clients to always consult with a tax professional prior to beginning 72T withdrawals.

 Death Benefit Is Still Tax-Free

Even if paid by a modified endowment contract, a death benefit can still be passed on to beneficiaries tax-free, assuming that the normal requirements for a tax-free death benefit under life insurance rules are met. This means that the policy owner and the insured person can not have been the same person for at least 3 years prior to the claim being paid.

Because the death benefit is still tax-free, a MEC is still useful for estate planning purposes.  If a policy owner has no intention of withdrawing the cash value during the insured person’s lifetime, there are no consequences of the life insurance contract qualification as a modified endowment contract.

An owner can still put a significant amount of money into a life insurance contract, have it grow tax-deferred until the death of the insured, and pass on a significant amount of money to the next generation free of taxes.  The maximum amount of money that can be accepted into either a life insurance contract or a modified endowment contract is still limited by guideline premium limits, another limit placed by the federal government to avoid excessive use of this tax benefit.

7 Pay Calculation

The total amount of money that can be put into a life insurance contract during the first seven years are determined according to law by the age the insured, the cost of insurance, the health risk rating, and assumptions about mortality rates and current interest rates.  While called the 7 pay test, it is not consequential how many payments are actually made, it refers to the cumulative premium payments that may be made in the first 7 years of a life insurance contract.  Each of the first seven years additional premium is allowed.  If there is excess premium allowed from one year it carries over to the next.  The 7 pay calculation will be given to you by your insurance company, or agent, and a warning will be given if this amount is exceeded.  Generally speaking, life insurance companies will allow you to withdraw the excess premium if this amount is exceeded, as long as it is done before the next policy anniversary.  Otherwise, a policy will be considered a MEC.

Used In Three Circumstances

The 7 pay test is used to test life insurance contracts in three distinct situations.

  1. During the first seven years of a life insurance policies’ life to test total premium payments.
  2. To re-test policies if the death benefit is reduced, which will reduce the aggregate 7 pay maximum.
  3. To re-test any policy which undergoes a material change (generally a change to death benefits or costs of insurance).

 Never Lose MEC Status

After a life insurance policy is considered a modified endowment contract, it can not be reclassified as a standard life insurance contract again.  This is true even if changes are made to the policy which would otherwise not caused the policy to become a modified endowment contract.  Because of this permanent classification, clients must always be aware of the tax consequences if they are in danger of over funding a policy under TAMRA.

Why Would you Want a Modified Endowment Contract?

In general, you would not wish to turn your regular life insurance contract into a MEC unless you are prepared for the tax consequences.  Typically, it is more efficient to purchase a whole life insurance policy and an annuity separately.  There may be times when you do want to overfund a life insurance policy for investment purposes.  If for instance, someone owns a whole life policy that typically receives an excellent dividend payment, and market interest rates are low, the total rate of return may actually be higher by overfunding the life insurance policy than it is by purchasing an annuity.

What Can you Do if Your Policy Becomes a MEC?

Unfortunately, you can not do anything to change the tax status of your policy after it becomes a modified endowment contract.  You can choose to continue to own it, and as long as you are not planning on taking withdrawals, or you are prepared to deal with the tax consequences if you are, you do not need to worry.  If you do not want to own a modified endowment contract any longer, you can purchase a new policy.  You may be able to fund it with the existing cash value of the modified endowment contract by using a 1035 exchange.  The new contract does not need to be a MEC if you do not wish to continue with that classification of life insurance.

Pros and Cons of a Modified Endowment Contract

After reading about all the advantages of a whole life insurance policy compared to a Modified Endowment Contract, it might seem like a MEC is a bad thing to have. The truth is MECs are neither good nor bad; their position depends on your financial goals.

A Modified Endowment Contract doesn’t prohibit you from receiving tax advantages, it just regulates your advantages. For some people, a MEC is a beneficial financial tool. Here are some reasons why you may want to have a MEC:

  • You don’t plan on accessing you cash value until after age 59 1/2
  • You want guaranteed returns with less volatility than the stock market
  • You want to increase the tax-free death benefit your heirs receive

On the other hand, there are reasons a whole life insurance policy might be more suited to your financial goals:

  • You need liquidity (penalty-free) before age 59 1/2
  • You want to use your cash value as your own personal banking system
  • You want tax-free income in retirement

Estate Planning With a Modified Endowment Contract

If your main financial goal is to pass on the most tax-free wealth possible to your family, a Modified Endowment Contract can be a great estate planning tool. Compared to other savings vehicles like CDs or money market accounts, MECs typically earn a higher interest rate. Essentially a single premium life insurance policy, funds are placed into a MEC in one lump sum or in a series of large payments in the first few years of the policy. From there, cash value rapidly accumulates.

Regardless of how you plan to use whole life insurance, it’s imperative that your policy is structured in a way that helps you accomplish your goals. The Wealth Strategists at Paradigm Life are experts in helping people all over the United States and Canada grow and protect their wealth. Schedule a complimentary consultation today to find the best policy for your needs.

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