A modified endowment contract (MEC) is a permanent life insurance policy that's been stripped of many tax advantages because it's overfunded. The IRS could determine that a policy is an MEC if both of the following statements are true:
- The policy was purchased on or after June 21, 1988.
- The policy fails the 7-pay test. Your insurer sets an annual premium limit based on the amount that would pay up the policy (meaning no further premiums would be required) in seven level premiums. If you pay more than the seven-pay limit in any year during the first seven years, the policy could be designated an MEC.
A modified endowment contract still carries a death benefit, but unlike most permanent life insurance policies, there are few tax breaks associated with the cash that accrues.
Where MECs came from
To better explain a modified endowment contract, let's go back to decades ago, when permanent life policies, such as whole life insurance policies, were all the rage. Term life insurance is in effect for a set number of years, but whole life insurance provides coverage throughout a person's life, as long as they pay their premiums as agreed. What really set whole life apart was that it was cash value life insurance. Part of each premium goes toward cash value that the policyholder could withdraw or borrow against.
Better yet, the cash paid into whole life policies earned a guaranteed rate of interest -- and a slew of tax advantages that made them safe havens. Keenly interested in investments that minimize taxes, policyholders put large sums into whole life policies. They got to protect their money from the IRS, and have a death benefit to help their beneficiaries get by if the policyholder died.
Eventually, lawmakers caught on that insurance companies were advertising whole life policies as a way to build cash value without paying regular tax rates. Congress was appalled that life insurance companies had created a tax shelter.
TAMRA regulation
In 1988, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA), which put strict limits on how much could be paid into a life insurance policy. And under the act, any overfunded policy would be moved into a new category -- a modified endowment contract.
Permanent life insurance vs. modified endowment contract (MEC)
When a permanent life insurance contract is converted to an MEC, it will still provide a tax-free death benefit to heirs. Cash value will also accumulate on a tax-deferred basis.
The big difference between a traditional life insurance contract vs. an MEC is that withdrawals and loans from an MEC receive less favorable tax treatment. With traditional cash value life insurance, your withdrawals are treated as a return of the premiums. You aren't taxed until your withdrawals exceed the amount you've paid in. Withdrawals from an MEC are first treated as coming from earnings, therefore, they're taxable. Once you've depleted the earnings, withdrawals won't be taxed. There's also a 10% penalty on withdrawals from an MEC before age 59 1/2.