What Is a Modified Endowment Contract? How Do You Avoid It?
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Shopping for life insurance raises a number of questions. For example, what is a modified endowment contract? By the time you've finished this article, you should know what a modified endowment contract (MEC) is, how it comes to be, and whether you want to embrace or avoid an MEC.
A modified endowment contract (MEC) is a permanent life insurance policy that's been stripped of many tax advantages because it's overfunded. The IRS could determine that a policy is an MEC if both of the following statements are true:
A modified endowment contract still carries a death benefit, but unlike most permanent life insurance policies, there are few tax breaks associated with the cash that accrues.
To better explain a modified endowment contract, let's go back to decades ago, when permanent life policies, such as whole life insurance policies, were all the rage. Term life insurance is in effect for a set number of years, but whole life insurance provides coverage throughout a person's life, as long as they pay their premiums as agreed. What really set whole life apart was that it was cash value life insurance. Part of each premium goes toward cash value that the policyholder could withdraw or borrow against.
Better yet, the cash paid into whole life policies earned a guaranteed rate of interest -- and a slew of tax advantages that made them safe havens. Keenly interested in investments that minimize taxes, policyholders put large sums into whole life policies. They got to protect their money from the IRS, and have a death benefit to help their beneficiaries get by if the policyholder died.
Eventually, lawmakers caught on that insurance companies were advertising whole life policies as a way to build cash value without paying regular tax rates. Congress was appalled that life insurance companies had created a tax shelter.
In 1988, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA), which put strict limits on how much could be paid into a life insurance policy. And under the act, any overfunded policy would be moved into a new category -- a modified endowment contract.
When a permanent life insurance contract is converted to an MEC, it will still provide a tax-free death benefit to heirs. Cash value will also accumulate on a tax-deferred basis.
The big difference between a traditional life insurance contract vs. an MEC is that withdrawals and loans from an MEC receive less favorable tax treatment. With traditional cash value life insurance, your withdrawals are treated as a return of the premiums. You aren't taxed until your withdrawals exceed the amount you've paid in. Withdrawals from an MEC are first treated as coming from earnings, therefore, they're taxable. Once you've depleted the earnings, withdrawals won't be taxed. There's also a 10% penalty on withdrawals from an MEC before age 59 1/2.
| Permanent life insurance policy | Modified endowment contract (MEC) |
|---|---|
| Tax-free death benefit for beneficiaries | Tax-free death benefit for beneficiaries |
| Tax-deferred cash value growth | Tax-deferred cash value growth |
| Withdrawals are treated as tax-free principal first | Withdrawals are treated as taxable gains first |
| No penalties for withdrawing cash value before age 59 1/2 | 10% early withdrawal penalty for withdrawing gains before age 59 1/2 |
| Policy loans aren’t taxable | Policy loans are taxable |
Your permanent life insurance policy could become an MEC if you overfund it by paying more than you'd need to fully fund the policy in the first seven years. If you buy single-premium life insurance, where you fully fund the policy with a lump-sum payment, it's automatically considered an MEC, as it fails the seven-pay test.
Any material changes to a policy's benefits trigger a new seven-year window. Material changes include increasing the policy's death benefit or adding certain life insurance riders.
Once a policy converts to a modified endowment contract, it cannot be reversed.
The 7-pay test (sometimes called the "seven-pay test" or "7-pay limit") determines when a policy becomes a modified endowment contract. Here's an example of how it works:
Suppose you purchase a $100,000 policy with annual MEC limits of $4,000. In years one and two, you pay $4,000 per year, but in year three, you pay $6,000. Because you've exceeded the aggregate MEC limit in the first seven years, the policy becomes an MEC. Once it exceeds that threshold, the policy becomes a modified endowment contract.
Your insurer will let you know when the cash in your life insurance policy gets dangerously close to the limit. Typically, you'll receive a notification warning you that too much has been paid in.
If you do nothing about the problem, the insurer informs the IRS that the life insurance policy has converted to a modified endowment contract. If you want to prevent the policy from becoming a modified endowment contract, you can request a refund of the overpayment from the insurer within 60 days of the end of your policy's contract year
Remember, though, that if your life insurance policy is converted to an MEC, it will still provide the same financial protection for your loved ones. MEC status will only come into play if you withdraw or borrow against the policy's cash value.
A person can set up a modified endowment contract as part of their estate planning, or they can overpay into a whole life policy, causing it to become a modified endowment contract. Once it's converted, it loses special tax status and is taxed like most other investment vehicles.
An MEC offers many of the same benefits as traditional permanent life insurance, including a tax-free death benefit. There are some situations when setting up an MEC could be advantageous, such as if you have a large amount of money you want to invest in a tax-deferred manner or if you want flexibility on your premium payments. Due to the complexity of life insurance contracts and MECs, discuss your options with a financial advisor.
Yes. Any money borrowed from gains earned on the money is taxable. However, any portion of the loan that's considered part of the principal isn't taxable.
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