What Is A Modified Endowment Contract, Often Known As A MEC?

If you have a whole life insurance policy, you are probably aware of its cash value account. This account is funded in part by your insurance premiums, and the investment grows tax-free. This tax advantage, while appealing, comes with a caveat.

If you contribute too much money to the account's cash value, the insurance may be considered a modified endowment contract, or MEC. While your life insurance coverage would remain unchanged, early withdrawal may result in additional taxes and penalties. However, if you understand how and when MEC regulations apply, you can escape the designation.

A Modified Endowment Contract Is What It Sounds Like.

A modified endowment contract is a life insurance policy that has surpassed the IRS contribution restrictions. If both of the following statements are true, the IRS will declare a life insurance policy to be a MEC:

•The policy becomes effective on or after June 21, 1988.

•The policy fails the "7-pay test."

The '7-Pay Test' Is Defined.

The IRS uses the 7-pay test to determine if a cash-value life insurance policy has been overfunded. These plans usually contain a yearly restriction on how much you may deposit into the account. This limit is based on the number of premiums required to pay off the coverage in the first seven years. To be fully paid up indicates that the coverage has been paid in full and that no more payments are necessary to keep the policy operational.

Policyholders may pay more than the minimum premium since the extra money is deposited into the cash value account and may increase the investment. However, if you pay more than the yearly maximum at any time during the first seven years, the policy will fail the 7-pay test and may be deemed a MEC.

For example, if your policy's yearly premium cap is $1,000 and you pay $2,000 in the second year of ownership, a MEC conversion will occur.

The 7-pay test applies throughout the first seven years of a policy's existence. If you make significant modifications to your coverage, the clock is reset for another seven years. A major change is defined as anything that modifies the coverage, such as raising the death benefit or adding a life insurance rider.

What Exactly Is Mec Insurance?

Life insurance and modified endowment contracts are quite similar. Because the death benefit stays intact, your life insurance beneficiaries will continue to receive the amount if you die. And the cash value account continues to grow tax-free. When you remove cash from the account, though, you may be exposed to greater taxes and fees than if you had a life insurance policy.

This is because the IRS treats withdrawals from a MEC differently. When you withdraw funds from a life insurance policy, the "policy basis" is deducted first. The basis is the money you've paid in premiums, and you may withdraw it tax-free. So, if you do not withdraw more than the base, you will not be taxed. The gains are extracted initially under a modified endowment contract, and they are taxed as regular income.

MEC withdrawals normally entail a 10% tax penalty if taken out before the age of 5912 years. The 10% applies exclusively to the gains, but because the gains are removed first, you will almost certainly pay the penalty.

Rider with paid-up additions

When investigating modified endowment contracts, you may come across the phrase "paid-up additions," or PUA. A PUA rider effectively allows you to add tiny sums of dividend-funded permanent life insurance. Policyholders can employ PUAs to improve the overall death benefit and cash value of their policy while maintaining the right insurance-to-investment ratio and avoiding a MEC conversion.

The Benefits And Drawbacks Of A Modified Endowment Contract

If your coverage is identified as a MEC, it does not always imply disaster. The MEC restrictions were put in place to prohibit policyholders from utilizing their life insurance plans as tax-free investment vehicles. If you don't intend to withdraw the money soon, you might significantly fund the account and use the tax-deferred growth for retirement or estate planning.

However, if you plan to take or borrow from the cash value before retiring, you should avoid MEC status.

Before making any permanent investing decisions with your life insurance policy, consult with a fee-only financial advisor.