Modified Endowment Contract: Good or Bad?

Life insurance as a high-growth, tax-sheltered investment was once all the rage in the United States. Many policyholders took advantage of this and invested large sums in their insurance without paying regular tax rates.

The US Congress and Internal Revenue Service (IRS) caught on to this tax avoidance practice and implemented the Technical and Miscellaneous Revenue Act (TAMRA) to control it. This US tax Act led to the Modified Endowment Contract (MEC).

What’s a Modified Endowment Contract (MEC)?

If a policyholder of cash-value life insurance pays their premiums too much and too fast, the policy’s legal tax will likely exceed the limits. When this happens, the policy will be declared a modified endowment contract (MEC).

Specifically, a life insurance policy turns into an MEC if it:

  • Was bought on or after June 20, 1988
  • Met the statutory or standard definition of a life insurance policy
  • Didn’t pass TAMRA’s “seven-pay” test

What’s the “7-Pay” test?

Policyholders will hear about the “7-pay test”, also called the “7-pay limit” or “MEC limit,” after they shop for Insurance during the first seven policy years. It’s the test the IRS uses to determine whether a policy has been overfunded.

Under TAMRA 1988, the 7-pay test calculates the cumulative amount paid under a policy within the first seven years. If the number exceeds what’s needed, the policy fails the test and will be recognized as an MEC. Note that it can’t be reversed once reclassified.

For example, a policyholder bought a universal life insurance policy worth $50,000 with an annual 7-pay limit of $1,000. If they put in $2,000 in Year 4, which exceeds the limit, the policy will be classified as MEC.

Note that the 7-pay test must be passed every single year of the first seven policy years. A new 7-pay period is only applicable if there are material changes to a policy, such as reducing the death benefit, changing face amount coverage, or adding riders.

Can All Types of Life Insurance Be Declared a MEC?

Not every type of life insurance can be subjected to the MEC rule. Only those policies with cash value can be declared MEC. Other types that only come with death benefit protection will be excluded.

Listed here are the most common life insurance types that can turn into MECs:

  • Permanent life insurance
  • Universal life insurance
  • Whole life insurance

These three come with cash accumulation benefits in addition to the death benefit. The accumulated funds can be withdrawn by the policyholders either through partial surrender or a loan on a tax-deferred basis (i.e., a tax that’s payable in the future).

Is Modified Endowment Contract Good or Bad?

An MEC is neither good nor bad. For many, it’s an excellent way to use in estate planning, while for others, it can be like a tax trap. To further understand, let’s discuss the advantages and disadvantages of MEC.

Advantages of MEC

If a policy becomes an MEC, the death benefit will still remain tax-free. Even in other non-MEC life insurance policies, it won’t generally be considered a part of a beneficiary’s gross income, so it’s often excluded from the federal income tax.

The cash value of MEC-classified policies will also continue to grow tax-deferred. Many policyholders with significant assets to keep in tax-deferred vehicles opt for it. Plus, at their demise, these estates will then go to their beneficiaries on a tax-advantaged basis.

Due to its capability to leave a tax-free inheritance, MEC policies are often touted as a sound estate planning tool. It’s marketed as a better alternative to annuities, which immediately become taxable at the policyholder’s demise.

Disadvantages of MEC

One of the main concerns on MEC-classified life insurance policies is their tax implications. Although the growth of cash value is tax-deferred, their withdrawals aren’t. They function like nonqualified annuities, where they’re funded with after-tax dollars.

In simpler terms, when policyholders borrow or withdraw the cash value of their MEC-classified insurance policies, they must pay taxes on the proceeds. They’re taxed this way because the IRS categorized these funds as ordinary income. Most of the time, cash value withdrawals are taxable if they exceed the premiums paid.

Another concern is that borrowing or withdrawing cash value can reduce the death benefit policyholders leave for their beneficiaries. The reduction can be higher than the amount withdrawn depending on the policy’s terms and the policyholder’s cash account.

Every life insurance policy differs from provider to provider. Hence, it’s better to contact your insurance agent or any representative from your life insurance to discuss how withdrawing cash value from your specific policy works.

Final Thoughts

A life insurance policy turned into an MEC isn’t always bad. It’s a tax-deferred vehicle, so it primarily benefits estate planning. Conversely, for those who think it’s a tax trap, simply follow the 7-pay limit to avoid it. If unsure, it’s highly recommended to do your research or, better, seek professional advice.

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