What is a modified endowment contract?
A modified endowment contract (MEC) is a term that refers to the automatic conversion of a cash value life insurance policy once it exceeds IRS restrictions.
In short, your insurance policy is now viewed as an investment vehicle by the IRS.
When you exceed the funding limit on your insurance policy, it will be converted into a modified endowment contract (MEC) — which makes you ineligible for any tax advantages associated with traditional life insurance policies.
Let’s define a modified endowment contract and explore how it works.
We’ll go further to describe how to avoid triggering an MEC — and what to do if your life insurance policy becomes a MEC.
How does a modified endowment contract work?
Even though there is “contract” in the name, a modified endowment contract (MEC) differs from the traditional “signature and terms” contract.
The MEC status typically affects cash value life insurance instead of term life insurance (death benefit).
According to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA 1988), the IRS can convert a life insurance policy into a MEC under the following conditions:
- The policy came into effect after June 20, 1988.
- The life insurance policy meets the official IRS definition.
- The policy fails the “7-pay” test.
But what is this 7-pay Test?
The seven-pay test or 7-pay test is a system the IRS deploys in order to determine if you’ve exceeded the acceptable limits when funding your cash value life insurance.
Here is how it works: Your insurance company specifies a pay limit according to the package you acquired. This will determine how much you have to pay over the first (next) seven years.
As humans, we often struggle to resist the urge to add as much money as possible to the life insurance contract.
While this might be a great investment strategy, it will harm you in the long term — that is, after the first seven years of the policy.
Once the IRS confirms that you’ve failed the 7-pay test — you’ve now exceeded your funding limit during the first seven years — you will lose all tax benefits that come with standard life insurance.
Your policy is now considered an investment, a modified endowment contract.
Usually, the life insurance company should notify the policy owner if their insurance policy is about to become an MEC.
But by the time the warning arrives, it might be too late to make changes to revert the process and avoid tax consequences.
How does an MEC differ from a life insurance contract?
Both MECs and life insurance contracts are insurance products.
By default, a universal life insurance contract does not attract negative tax implications for early withdrawals.
This condition applies to policyholders below or above the age of 59.5 years old.
However, an MEC policy deprives you of all tax deferral advantages if you are younger than 59.5 years old.
And in addition, you’ll have to pay a 10% penalty for early withdrawals according to TAMRA tax rules.
MECs are also similar to non-qualified annuities in terms of taxation on withdrawals; they are funded with post-tax funds.
Under the “last-in, first-out” (LIFO) approach, the IRS considers taxes on gains “regular income” for MEC withdrawals.
Conversely, traditional life insurance policies follow the “first-in, first-out ” “FIFO” basis.
To avoid your life insurance policy converting into a MEC status, you can increase the death benefit using paid-up additions (PUA) — which compound indefinitely with time.
PUAs increase your limit without increasing your premium payments, allowing you to add more funds to your life insurance contract.
Unpaid policy loans are taxable under cash value life insurance policies; not so with MECs.
Is a modified endowment contract beneficial?
A modified endowment contract could be a double-edged financial sword: it could strip you of your tax shelter or help you plan your estate.
When your policy attains the MEC status, your beneficiaries can still obtain a tax-free death benefit from your life insurance contract.
This makes MECs suitable for retirement planning because it lets you place some assets in tax-deferred individual retirement accounts (IRAs).
Since your MEC policy now works as an investment, you will continue to gain returns with limited volatility.
Also, seniors with MEC policies can get other benefits as substitutes for expensive term life insurance, which can be used for elder care and assisted living in nursing homes.
The main drawback to MEC is that it is permanent. Once your standard life insurance policy goes into MEC mode, you can never revert it to normal.
How to avoid MEC
Unless you intentionally want to convert your life insurance coverage into a MEC policy, you need meticulous financial planning to manage how much you pay in monthly or yearly premiums.
As mentioned earlier, an insurance agent from your carrier will notify why when your premiums are edging closer to the stipulated limit.
If a single premium puts you over the limit, you can reclaim the additional funds within a specific period to make sure it doesn’t trigger the MEC status.
Alternatively, you can purchase PUAs to increase the ceiling in order to prevent overfunding your account. These funds could also accrue dividends over time.
In general, you have to monitor changes in legislation as well as the amount of premiums left to reach your account limit.
If you don’t have the time and expertise to handle the stress, speak to your financial advisor for proper guidance.
Use a modified endowment contract to your advantage
Your life insurance policy can change its status to a modified endowment contract when you overfund it.
So you need to keep track of your tax returns and annuities in order to make sure your premium doesn’t exceed the limit of your corridor’s ceiling.
But if your cash value life insurance policy becomes a MEC, you can use this opportunity for estate planning as well as boosting your retirement plan.
This will also come in handy for policy owners looking to establish a tax-free medium for added financial security.
Want to find out more about filing taxes and different tax forms?
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