What is a modified endowment contract, or MEC?

Creating a plan that prepares your family for a life of financial security is top-of-mind for many people. This often means managing the impact taxes have on your finances. Options like cash value life insurance can provide unique tax benefits that may be helpful both during your life and after you've passed on. Funds inside cash value life insurance can grow tax-deferred, and it might be possible to access your cash value without taxation through loans and withdrawals. And, of course, beneficiaries typically don't pay income tax on a death benefit.

But as with chocolate cake, it's possible to have too much of a good thing. When a contract is classified as a modified endowment contract (MEC), the rules get more restrictive.

Fortunately, a MEC keeps some of the most valuable tax benefits of life insurance. You might even choose to make your contract a MEC in some cases. Let's dig into how MECs work along with their advantages and disadvantages.

A MEC is a life insurance contract that receives premium payments in excess of certain Internal Revenue Code (IRC Section 7702A) limits. When that happens, withdrawals (including loans and loan interest) from the contract may not qualify for tax-free treatment until you've reported all of the earnings in the contract as taxable. However, the death benefit remains free of federal income tax for beneficiaries. As a result, income tax consequences generally only apply if you take distributions from the contract while the insured is living—which might never happen.

When using life insurance with a cash value, you may have the option to make substantial payments into your contract. Doing so enables you to fund the internal policy costs, helping to keep the policy in force for an extended period and benefit from tax-deferred growth inside of the contract.

MECs are possible with cash value life insurance contracts. When designing a strategy, you might have a goal of adding as much premium as possible to a contract, as bigger payments may lead to a larger cash value. That cash value may provide more compound growth, and there may be other benefits of a sizable cash value. But if your payments exceed IRC limits, the contract becomes a MEC.

In contrast to cash value life insurance, term life insurance lasts for a limited time and usually does not have cash value. Typically term life insurance is not tested for MEC status because there is no cash value to access during the life of the insured, only a death benefit payable to beneficiaries.

Tax rules limit how much you can add to a policy. The seven-pay test, in particular, determines if a contract will be a MEC. That test evaluates how much you would need to pay in premiums to fully fund a policy. Then you compare that amount with the premiums you actually pay during the first seven years. Certain material changes to the contract may result in a reapplication of the seven-pay test. In addition, any reduction in benefits during a seven-pay testing period—including where a policy lapses and is then reinstated more than 90 days later—will affect the application of this test.

If your payments exceed the seven-pay test amount, the contract becomes a MEC. You might do that intentionally or accidentally. Either way, your insurer typically notifies you when you trigger MEC status. Calculating the seven-pay limit is best left to your insurer, and you can often get those numbers in advance from an agent.

A contract will also become a MEC if it is received in exchange for another life insurance contract that was a MEC.

Many people prefer to avoid MEC status, especially when they intend to access the cash value in a contract during the insured's lifetime. But there may be situations when a MEC is acceptable and even attractive.

Loans and withdrawals are taxed differently when using a MEC. Any distributions from a MEC receive last-in, first-out treatment. Premium payments go in first, and any earnings in the contract are added last. As a result, you would owe income tax on loans and withdrawals until you use up all of the earnings in a contract. Distributions made within two years before a failure to meet the seven-pay test are also treated as made under a MEC. If you own more than one MEC purchased from the same company in the same year, the policies will be aggregated for purposes of determining the amount that is taxable (i.e., you'll have to report tax on the earnings of all aggregated MECs before you can access the tax-free investment in any of the contracts). In addition, if you're younger than 59½, you may owe an early withdrawal penalty on earnings distributions, if any exception does not apply.

Contrast that with a non-MEC policy. With those contracts, you can use loans or withdrawals on a first-in, first-out basis. You would be able to withdraw your investment in the contract ("basis") before you start using earnings and creating a tax liability.

If you don't plan to access the cash value in a contract during the life of the insured, it may not matter if the contract is a MEC. But this is critical to understand if you intend to use loans or withdrawals.

When a life insurance contract becomes a MEC, the cash value continues to grow in the contract tax-deferred. That may be appealing if you need life insurance coverage, do not expect to access the value while the insured is living, and want to shelter growth on that asset from annual taxation. However, if you access the funds during the life of the insured, you'll pay tax on withdrawals from the MEC until you get down to your investment in the contract.

As life insurance contracts, MECs pay a death benefit that is generally not included in the beneficiary's gross income for federal income tax. Of course, that applies to non-MEC policies as well, so beneficiaries do not face a disadvantage in this area. Because of this, MECs can still be an effective way to leave a substantial legacy to your loved ones.

Permanent life insurance policies often allow you to make sizable payments into your contract. If you're willing to have your policy become a MEC, you can make even bigger payments or pay into a contract more quickly than you might otherwise.

Other tax-deferred accounts, such as individual retirement accounts¹ (IRAs), often have annual contribution limits and result in tax when withdrawn by you or your beneficiaries. A MEC might be an appropriate solution if you have significant assets that you'd like to place in a tax-deferred vehicle. Then those assets can go to beneficiaries at death on a tax-favored basis.

Cash value life insurance can be a flexible tool for managing your assets and providing for your loved ones after you pass away. However, it's crucial to understand how tax rules relate to MECs.

If a policy becomes a MEC, accessing the cash value through loans and withdrawals may cause taxation that you wouldn't face with non-MEC policies. However, using a MEC allows you to put a substantial amount into a life insurance contract—more than you can place in many other tax-deferred vehicles. And all is not lost when a contract becomes a MEC. Beneficiaries still receive a death benefit that's excluded from federal income tax, helping to provide financial security and funds for essential goals.

To learn more about the range of options available, speak with a financial advisor. You can discuss the pros and cons of different strategies, check out specific numbers and get answers to all of your questions.