Permanent life insurance policies are typically granted generous tax advantages because they allow you to transfer money to your heirs upon death. Life insurance policies protect your loved ones from a financial crisis after you are gone.
A portion of each life insurance premium you deposit is allocated to the policy’s cash value. The policy’s cash value can grow tax free. A modified endowment contract (MEC) is a label that the Internal Revenue Service (IRS) places on a permanent life insurance policy that has been overfunded with too much cash.
Once the IRS labels a life insurance policy as a MEC, it loses its tax advantages for withdrawals and loans that you might make from the policy. Since a policy labeled as a MEC is a permanent change, it is important to understand the consequences of paying excess premiums into a cash-value life insurance policy too quickly.
Term life insurance policies do not offer a cash accumulation benefit and are not subject to MEC treatment. For more personalized advice, contact us to speak with a financial advisor near you.
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What is a MEC?
In the past, cash-value life insurance policies allowed policyholders to place substantial amounts of money in these policies. Policy owners could then withdraw both the loan’s principal and interest as a tax-free loan. These policies could be used as a way to sidestep capital-gain taxes, in addition to providing a death benefit.
What is the 7-pay test?
In 1988, Congress passed the Technical and Miscellaneous Revenue Act of 1988, which created the MEC classification. Any cash-accumulating policy can be labeled as a MEC if it was issued on or after June 21, 1988, it meets the definition of a life insurance policy, and it cannot pass the “7-pay test.” This test compares the total premiums you pay into the policy in the first seven years with the total needed to fund the policy fully.
How does your life insurance policy fail the 7-pay test?
Cash value life insurance policies typically have an annual limit you can pay into the account. This annual limit is based on the total amount of premiums you would need to pay in 7 years to pay for the coverage in full. The incentive to pay more than the annual premium is that the additional money may boost the cash value of the policy. If you pay more than the annual limit in the first seven years, the policy will fail the 7-pay test and trigger a MEC classification.
If you make a material change in your life insurance policy, a new 7-pay period begins, and the test is re-applied. Examples of material changes include face amount increases, adding riders, plan changes, and the exchange of insureds. Renewing a policy that was established before June 21, 1988, makes it a new policy and, therefore, subject to the 7-pay test.
What are the tax implications for a MEC?
If your life insurance policy is classified as a MEC, it is still eligible for tax-free death benefits and tax-deferred cash accumulation. As long as you do not take any distributions from your policy, the tax implications of a MEC will not apply.
When you withdraw money from a life insurance policy, the amount you have contributed through your premiums can be withdrawn tax-free. The first-in-first-out (FIFO) accounting method is used to determine tax treatment. As long as you don’t take a distribution that is higher than your policy basis, you won’t be taxed.
Only when you take withdrawals from your MEC are the earnings taxed. The IRS treats the money you have withdrawn as ordinary income. The last-in-first-out (LIFO) accounting method is used, which means that taxable interest is distributed before the tax-free principle.
Once a policy is classified as a MEC, withdrawals are treated like a nonqualified annuity. If you take a distribution from your MEC and are younger than 59 1/2 years old, the distribution is subject to an additional 10% penalty. An exception to the penalty is also made if you have become disabled.
How can you avoid MEC status?
Your life insurance company will typically notify you if you have overpaid on your life insurance policy and give you the opportunity to reclaim that money within a certain period of time.
It is essential to understand the potential financial implications of overfunding a cash-accumulating life insurance policy. Once a policy is classified as a MEC, the classification is permanent, and the policy loses its tax benefits.
MECs are not without their benefits. Their tax-free death benefits make them a helpful estate planning tool. MECs provide a low-risk way to save money and pass it on to your beneficiaries. Money invested in a MEC typically earns a higher return than money deposited in savings accounts or certificates of deposit (CDs).
There is no one-size-fits-all guide to investment. Working with a wealth manager can ensure you make the best financial decisions for yourself and your loved ones.
Gabriel Katzner
In 2002, Gabriel Katzner received his Juris Doctorate with honors from Fordham University School of Law. After spending the first seven years of his legal career practicing at Cahill Gordon & Reindel LLP, an international law firm based in New York, he founded his own firm.
Gabriel identified key limitations in traditional estate planning—particularly the transient nature of client interactions and the suboptimal financial advice clients received elsewhere. Motivated to provide more enduring and comprehensive financial guidance, Gabriel established Frame Wealth Management. His aim was to extend client relationships and enhance their financial strategies, ultimately leading him to become a CERTIFIED FINANCIAL PLANNER™ and a CPWA® professional.
Years of Experience: 17+
