7.3 Modified Endowment Contracts (MECs)
Before 1988, individuals could deposit large amounts of money into a cash value life insurance policy, often as a lump-sum payment. The funds inside the policy would grow on a tax-deferred basis, and when the insured died, the death benefit would be paid to the beneficiary income tax free. If the policyowner needed access to the funds during their lifetime, they could take tax-free policy loans or withdrawals. Because of these advantages, some people used these policies primarily as tax-advantaged investment vehicles rather than for insurance protection.
Under current tax law, if a life insurance policy is funded too rapidly, it may be classified as a Modified Endowment Contract (MEC). MEC regulations were created to discourage the use of life insurance as a short-term tax shelter. These rules impose stricter taxation and penalties on withdrawals and loans from such policies.
7-Pay Test
If a life insurance policy fails the 7-pay test, it is classified as a Modified Endowment Contract (MEC). The 7-pay test limits the amount of premium that can be paid into a policy during the first seven years of the contract.
This test compares the total premiums paid into the policy during the first seven years with the net level premiums that would have been required to fully pay up a whole life policy in seven years for the same death benefit. As long as the premiums paid remain within these limits, the policy will avoid being classified as a MEC.
If the policyowner pays premiums that exceed the allowable limits, the insurer may refund the excess premium within 60 days after the end of the policy year. Because a single-premium life insurance policy is funded all at once, it automatically fails the 7-pay test and is therefore classified as a MEC.
Other policies that may become MECs include flexible premium policies, such as Universal Life and Variable Universal Life. The flexible premium structure allows policyowners to make contributions at varying times and amounts, which can potentially lead to overfunding.
Once a policy is classified as a MEC, the designation is permanent for the life of the policy, and the classification cannot be reversed in later years even if future premiums follow the guidelines.
Taxation
If a life insurance policy is classified as a Modified Endowment Contract (MEC), distributions from the policy are taxed under the Last-In, First-Out (LIFO) rule rather than the standard First-In, First-Out (FIFO) treatment.
Under LIFO taxation, the earnings in the policy are considered to be withdrawn first, meaning that the initial amounts taken from the contract are treated as taxable income rather than a return of principal. As a result, these distributions are taxed as ordinary income.
Taxable distributions from a MEC may include partial withdrawals, full cash value surrenders, and policy loans, including automatic premium loans.
Penalties
When a life insurance policy is classified as a Modified Endowment Contract (MEC), all distributions from the cash value are subject to taxation and potential penalties. Any gains withdrawn from the policy before age 59½ are generally subject to a 10% early withdrawal penalty, in addition to ordinary income tax. This is considered a premature distribution.
However, the 10% penalty does not apply to distributions made after age 59½ or to distributions that occur due to the death or disability of the insured.
Quiz
1. Why were Modified Endowment Contract (MEC) rules created?
A. To increase life insurance policy sales
B. To prevent life insurance from being used primarily as a short-term tax shelter
C. To eliminate tax benefits from life insurance entirely
D. To reduce the number of permanent life insurance policies issued
Correct Answer: B
Rationale: Before 1988, individuals could heavily fund life insurance policies and use them mainly for tax-deferred investment growth and tax-free loans. MEC rules were introduced to discourage the use of life insurance as a tax shelter rather than for protection.
2. What determines whether a life insurance policy becomes a Modified Endowment Contract?
A. The age of the insured
B. The amount of the death benefit
C. Failure of the 7-pay test
D. The type of insurance company issuing the policy
Correct Answer: C
Rationale: A policy becomes a Modified Endowment Contract if it fails the 7-pay test, which measures whether the policy has been funded too quickly during the first seven years compared to the premium limits for a seven-year pay whole life policy.
3. Which type of life insurance policy automatically fails the 7-pay test and becomes a MEC?
A. Term life policy
B. Single-premium life insurance policy
C. Group life insurance policy
D. Credit life insurance policy
Correct Answer: B
Rationale: A single-premium life insurance policy is funded entirely with one large payment at the beginning. Because this exceeds the allowable premium limits for the 7-pay test, it automatically qualifies as a MEC.
4. How are distributions from a MEC generally taxed?
A. First-In, First-Out (FIFO)
B. Last-In, First-Out (LIFO)
C. Capital gains taxation
D. No taxation applies
Correct Answer: B
Rationale: MEC distributions follow the Last-In, First-Out (LIFO) rule. This means earnings are considered withdrawn first, making them taxable as ordinary income before the return of principal.
5. What penalty may apply if gains are withdrawn from a MEC before age 59½?
A. 5% penalty
B. 10% penalty
C. 15% penalty
D. No penalty applies
Correct Answer: B
Rationale: Withdrawals of gains from a MEC before age 59½ are typically subject to a 10% early withdrawal penalty, in addition to ordinary income tax. This penalty does not apply if the distribution occurs after age 59½ or due to the insured's death or disability.