What Is An Mec? Life Insurance Explained

A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. MECs are subject to specific tax consequences, such as taxes and penalties on withdrawals and loans. MECs are often the result of overfunding a permanent life insurance policy beyond federal tax limits. While MECs can be useful for estate planning, they are generally disadvantageous for policyholders as they lose the tax advantages of traditional life insurance policies.

What is a Modified Endowment Contract (MEC)?

A modified endowment contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. Once the Internal Revenue Service (IRS) reclassifies a life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans from the policy. This permanent change can occur when you pay excess premiums in too short a period.

History of MECs

In the 1970s, many life insurance policies offered substantial cash value accumulation, allowing policyholders to withdraw interest and principal in the form of a tax-free loan. This effectively made the policies tax shelters. Federal legislation passed in 1988 limited this type of use, creating the MEC.

Criteria for an MEC

The IRS has three criteria for a life insurance policy to be considered an MEC:

• The policy was entered into on or after 20 June 1988.
• It meets the statutory definition of a life insurance policy.
• The policy fails to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) "seven-pay test".

The Seven-Pay Test

The seven-pay test determines whether the total amount of premiums paid into a life insurance policy within the first seven years exceeds what you would need to pay it off in full for those seven years. Policies become MECs when the premiums paid exceed what was needed to be paid within the seven-year time frame.

Tax Implications of an MEC

The taxation of payouts for an MEC is worse for the policyholder because it provides for taxable interest to be distributed first, rather than the tax-free principal. In addition, withdrawals under an MEC are taxed and possibly penalized if they occur before the policyholder reaches the age of 59 and a half.

Pros and Cons of MECs

MECs offer a higher yield on low-risk funds than some alternatives, allow for a smooth, tax-free asset transfer after the holder's death, and provide a way to borrow against the cash value component. However, they also erase tax advantages for withdrawals and loans, make the cash value in the policy less accessible, and may reduce the death benefit for heirs.

How does an MEC affect the tax benefits of a life insurance policy?

A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. Once the Internal Revenue Service (IRS) relabels your life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans that you make from the policy. This permanent change can happen when you pay excess premiums in too short a period.

Permanent life insurance contracts are generally granted generous tax advantages in the U.S. However, if you put too much cash into one, it loses its status as "insurance" and becomes an investment vehicle instead. The MEC limits for a policy depend on its terms and death benefit amount. Your insurance company will warn you if a policy is about to become, or has become, an MEC.

The IRS limits on the amount of cash in a policy are in place to avoid abusing the tax advantages available from permanent life insurance. A life insurance policy must fail to meet federal guidelines called the "seven-pay test" to be classed as an MEC.

One of the disadvantages of an MEC is that withdrawals are taxed and possibly penalized if early, similar to those taken from non-qualified annuities. The taxation of withdrawals under an MEC is also similar to that of non-qualified annuity withdrawals. For withdrawals before the age of 59 1/2, you may need to pay the IRS a premature withdrawal penalty of 10%.

Another drawback of an MEC is that it removes the tax benefits for policy loans. In a traditional life insurance policy, you can borrow your cash value, including your earnings above premiums paid, without owing income tax. However, in an MEC, taking out your gains through a loan counts as a taxable withdrawal. The 10% premature penalty also applies before the age of 59 1/2.

Despite these disadvantages, MECs may be useful for some because they often offer a better low-risk yield than savings accounts do and can ease asset transfer upon the owner's death. MECs allow for the tax-free shifting of assets to beneficiaries, without probate proceedings, upon the owner's death.

How can I avoid my life insurance policy becoming an MEC?

To avoid your life insurance policy becoming a Modified Endowment Contract (MEC), you need to understand how MECs came about and how they are defined.

History of MECs

In the 1970s and 1980s, many life insurance policies offered substantial cash value accumulation. Policyholders could withdraw interest and principal in the form of a tax-free loan, which made the policies de facto tax shelters. In 1988, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) to limit this use of life insurance policies.

Definition of an MEC

An MEC is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. An MEC is defined by three criteria:

• The policy was entered into on or after 20 June 1988.
• It meets the statutory definition of a life insurance policy.
• The policy fails to meet the TAMRA "seven-pay test".

The seven-pay test determines whether the total amount of premiums paid into a life insurance policy within the first seven years is more than what you'd need to pay it up in full for those seven years. Policies become MECs when the premiums paid exceed what was needed to be paid within the seven-year time frame.

How to Avoid Your Policy Becoming an MEC

To avoid your life insurance policy becoming an MEC, you need to ensure that it does not meet the above criteria. In particular, you need to avoid overfunding your policy within the first seven years. You can do this by staying informed about the maximum allowable premium payments and by asking your insurance agent or carrier about their policy for handling excess premiums. Your insurance company will also warn you if your policy is at risk of becoming an MEC.

What are the pros and cons of an MEC?

Modified Endowment Contracts (MECs) are a type of life insurance policy that has lost its tax benefits because it contains too much cash. Once the IRS relabels a life insurance policy as an MEC, it loses the tax breaks for withdrawals and loans. This permanent change can happen when you pay excess premiums in too short a period.

Pros

• Higher yield on low-risk funds: MECs often offer a higher yield on effectively riskless money than savings accounts or certificates of deposit (CDs).
• Tax-free asset transfer after death: MECs allow for the tax-free shifting of assets to beneficiaries, without probate proceedings, upon the owner's death.
• Can be borrowed against: MECs provide a way to borrow against the cash value component, although taxes apply for taking out the policy earnings even through a loan.
• Maintains tax-free death benefit: MECs lose their tax advantages prior to the death benefit but maintain them post-benefit, meaning the death benefit is still tax-exempt.
• No ongoing premiums: MECs are often purchased by people who want to make a single premium payment and not have to worry about ongoing premiums.
• Privacy and incontestability: MECs offer privacy and incontestability for beneficiaries, unlike transfers dictated by a will.
• Creditor protection: MECs may offer protection from creditors in many states.
• Fast tax-deferred growth: MECs offer tax-deferred growth of the cash account, and the faster you fund your policy, the sooner you can begin to grow your cash account.
• Control over proceeds: MECs allow you to control the proceeds from your grave, preventing your beneficiary from misusing their inheritance.
• Access to face amount: Some MEC policies allow you to access the face amount in the event of a terminal illness or catastrophe, and some also offer long-term care benefits.

Cons

• Loss of tax advantages: MECs lose the tax advantages of traditional life insurance policies, including tax-free withdrawals and loans.
• Taxes and penalties on withdrawals: Withdrawals from MECs are taxed as income, and if you're under 59.5 years old and not disabled, you'll have to pay an additional tax of 10% for distribution.
• Taxes on loans: Policy loans from the cash value are treated as ordinary income and may be subject to income tax.
• Reduced death benefit: Borrowing against the cash value may reduce the amount of the eventual benefit paid to heirs.
• Less accessible cash value: The funds inside an MEC become less accessible due to the potential tax assessed on withdrawals and loans.
• Negative tax implications in emergencies: While emergency withdrawals may be allowed, the negative tax implications may outweigh the benefits.
• Potential for large tax penalties: There could be large tax penalties if you need to access the cash values before it's time to do so.

What are the tax consequences of withdrawing money from an MEC?

A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost its tax benefits because it contains too much cash. The Internal Revenue Service (IRS) reclassifies a life insurance policy as an MEC when it fails to meet federal guidelines, specifically the "seven-pay test". This test assesses whether the premiums paid within the first seven years of the policy exceed the amount required to pay off the policy. When a policy is reclassified as an MEC, it loses the tax breaks for withdrawals and loans.

The tax consequences of withdrawing money from an MEC are as follows:

• Withdrawals are taxed as regular income, with gains being distributed first and taxed at a higher rate.
• Withdrawals before the age of 59 1/2 may be subject to a 10% premature withdrawal penalty.
• Policy loans are treated as taxable withdrawals, with the same 10% penalty applying to those under 59 1/2.
• Borrowing against the policy may reduce the death benefit for heirs.

Despite these tax consequences, MECs can still be useful for some individuals as they offer a higher yield on low-risk funds than some alternatives, allow for a smooth, tax-free asset transfer after the holder's death, and can be borrowed against.

Frequently asked questions