What Is a Modified Endowment Contract?

Lynda Taylor is an assistant director of Risk Product Development at Northwestern Mutual.

Permanent life insurance offers many benefits, prompting many people to include it as a part of their broader financial plan. One such benefit is the ability of these accounts to accrue cash value, which grows tax deferred over time.

There are, however, limited situations in which these tax advantages can be lost—such as when the IRS classifies a policy as a modified endowment contract (MEC). This automatically happens when you have paid large amounts above your required premium, sometimes referred to as “overfunding.”

Below, we take a closer look at what a MEC is and why they exist. We also explain the implications of a life insurance policy becoming a MEC and outline the criteria used by the IRS to classify the policy as a MEC. Finally, we offer advice that you can use to avoid your insurance policy becoming a MEC so that you can continue to enjoy the tax advantages offered by permanent life insurance such as whole life insurance.

What is a modified endowment contract?

A modified endowment contract (MEC) is a cash-value life insurance policy that has been overfunded—typically in the first seven years--causing the IRS to strip it of its status as an insurance contract and consider it an investment vehicle. It could happen if someone gets a large windfall and puts a big chunk of the money into their life insurance policy.

Permanent life insurance policies accrue cash value, which policyholders can borrow against and access at any time for any reason once they have accrued a certain amount. Importantly, these withdrawals are usually not taxed if they are less than the premiums paid. Loans are usually not taxed unless the policy is surrendered or otherwise lapses before the loan is repaid.

Modified endowment contracts still accrue cash value. But if you take a loan or make a withdrawal from a MEC you will owe income tax on any growth. You’re required to withdraw growth first. You may have to pay a 10 percent penalty if you take money out of the policy before you are 59½ years old.

Why do MECs exist?

Prior to the creation of MECs, the tax benefits offered by permanent life insurance policies made it possible for policyholders to realize significant tax-advantaged growth by overfunding their policies. This could be achieved through either a series of overpayments or even just a single large payment early in the policy. In other words, permanent life insurance could become a way to avoid some taxes on the growth.

To prevent this, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) of 1988. This law created modified endowment contracts and established a set of criteria that the IRS could use to determine whether a life insurance policy should be considered a MEC.

How does the IRS determine which insurance policies become MECs?

In order to become a MEC, a life insurance policy must meet three criteria:

• The policy was bought on or after June 21, 1988;
• The policy meets the legal definition for a “life insurance policy,” and
• The policy fails the “seven-pay” test.

And it’s worth pointing out that this is not a problem for term life insurance. A policy can become a MEC only if it has the ability to accrue cash value, so these rules apply only to permanent life insurance policies (including whole life, universal life and variable universal life). And the tax penalty is relevant only for someone under age 59½ who takes money out of the policy.

The seven-pay test

The seven-pay test is a key measure that the IRS uses to determine whether a life insurance policy has been overfunded to the extent that it’ll be classified as a MEC.

It works like this: The IRS calculates how much money in premiums you would have to pay into your policy to fully fund it (requiring no further premium payments) using seven equal annual payments within the first seven years that the policy is in effect. This annual dollar amount is known as the “MEC limit.” If you exceed this amount in any of your policy’s first seven years, it will become a MEC.

The good news? Your MEC limit is clearly outlined in your policy’s contract. Your life insurance company would warn you if your payment would reach the MEC threshold. Your financial advisor can help you understand the pros and cons of applying an additional payment to the policy.

One thing to remember: If you make any changes to your policy—for example, increasing or decreasing coverage—the clock resets on the seven-pay test. When you make the change, the insurance company will let you know what amount would cause the policy to become a MEC.

What happens to a policy once it becomes a MEC?

First, let’s review what won’t happen if your life insurance policy becomes a MEC:

• You won’t lose your death benefit.
• You won’t lose the cash value that the policy accrues.
• You won’t lose tax-deferred status on the cash value growth.

The primary difference with a MEC policy is that for a withdrawal against your MEC’s cash value, you will first withdraw the gains that your contributions have enjoyed. It’s only after these gains have been exhausted that you will then pull from contributions. Since the gains have not had any income taxes paid against them, you’ll owe those taxes when you make your withdrawal—at your regular income tax rate. You’ll also owe a 10 percent penalty for any withdrawals before you are 59½.

Can a MEC be reversed?

No. You may be able to get a refund of your premium to avoid a MEC, but once a life insurance policy becomes a MEC, the process cannot be reversed. This is why it’s so important to know what your MEC threshold is and to understand whether a payment will exceed it.

But you can avoid the penalty if you wait until after age 59½ to take a withdrawal.

How to avoid classification as a MEC

The good news is that you can avoid your life insurance policy becoming a MEC.

First, when you purchase your policy, be sure to take note of the MEC threshold; structure your premium payments so that they do not exceed this amount in the first seven years. This will ensure you don’t fail the seven-pay test.

Also, remember that your life insurance company will notify you if you are at risk of going over your policy’s MEC limit. With this in mind, regularly review your policy’s documents, and always read any letters and emails sent by your provider.

Finally, it can be a good idea to consult with a financial advisor who understands the details of your policy. You may also want to consult a tax professional. They can help you understand the role that permanent life insurance can play in a comprehensive financial plan—while avoiding the tax risks that could result from overfunding your policy.

The primary purpose of permanent life insurance is to provide a death benefit. Utilizing the cash value through policy loans, surrenders, or cash withdrawals may reduce the death benefit; and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event.