MEC: Modified Endowment Contract Basics

Modified Endowment Contracts: Chapter 1 of 5

The MEC, or modified endowment contract was created to prevent life insurance policyholders from using the cash value of their universal or whole life policies as a tax-sheltered source for personal loans. In the late 1970′s, single pay life insurance products became popular as a vehicle for deferring investment gains while still allowing investors to take principal-first, tax-free disbursements. The Technical Corrections Act of 1988 created the modified endowment contract as a response to this phenomenon.

MEC Basics

Modified endowment contracts are contracts with fewer than seven level annual premiums, and are subject to stringent tax regulations and annuity rules similar to those of an IRA, such as penalties for receiving proceeds before death, or before a certain age. Under the federal tax law, the definition of “life insurance” now places limits on your ability to pay certain levels of premiums, under something called the “7-Pay Test” or the “7-Pay Limit.”

7 Pay Limit

A life insurance contract becomes a MEC if, during the first seven years that the policy is in force, a material change is made and/or the policyholder’s premiums exceed the 7-Pay limit. What this means is that, if your cumulative premium payments during the first seven years of the contract exceed a certain amount, your policy will be defined as an MEC, and it will be subject to a different tax treatment. Additionally, the government may impose a tax penalty of 10%.

MEC Taxes

If your policy becomes an MEC, any distributions from your policy during the lifetime of the policyholder will be subject to additional taxes. Any death benefit provided by your policy will still qualify for tax-free treatment.

If it is important to you to be able to access the funds in your insurance policy on a tax-free basis during your lifetime, you should speak to your life insurance agent to make sure you are adhering to the tax law limits when funding your policy, or making changes to your policy to avoid triggering MEC rules.

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