How to avoid a MEC (or a Modified Endowment Contract)
Are you planning to use cash value life insurance for tax-free income in retirement? Will your life insurance backfire? It could if it’s a Modified Endowment Contract.
You may not be familiar with the term Modified Endowment Contract, or MEC. But if you’re using life insurance primarily as a way to build up tax-deferred savings and / or as a tax-free source of income in retirement, then knowing what a MEC is – and how to keep your policy becoming one – is essential.
What is a MEC or Modified Endowment Contract?
A Modified Endowment Contract, or MEC, is defined as being a special type of life insurance policy under federal income tax law – and these policies are actually subject to special tax treatment.
Prior to the IRS enacting rules pertaining to Modified Endowment Contracts, it was possible to put large amounts of cash into a life insurance policy where the funds grew tax-deferred, along with the policy’s death benefit being received income tax-free by the beneficiary.
Because of this, many investors were using cash value life insurance policies in place of other investment vehicles where the earnings are subject to tax. While you can still use cash value life insurance today as a way to accumulate tax-deferred growth, the IRS has put forth certain rules – and if these are not followed, the policy could lose its tax-advantaged status.
How to Avoid a MEC
The law now prescribes a test that is intended to differentiate between life insurance policies that are purchased primarily for certain tax advantages, versus policies that are purchased primarily for the death benefit protection.
Under current law, money that is accessed from a MEC in the form of policy or premium loans, as well as surrenders, assignments, pledges, withdrawals, or loans secured by the policy is subject to income tax (as well as possibly subject to penalties).
So, while a Modified Endowment Contract provides a death benefit, the cash value gains can be taxed when accessed. (However, the principal – or cost basis – will not be taxed, unless these funds originated from prior un-taxed investment proceeds).
The IRS uses a 7-pay test to help determine whether or not a life insurance policy is a MEC. In this case, the test is designed for discouraging premium payment schedules that will ultimately result in having a paid-up life insurance policy prior to the end of a seven-year period of time.
According to the IRS, there are several situations where the 7-pay test applies. First, all life insurance policies that are entered into after June 20th, 1988, are tested. And, if the death benefit is reduced within the first seven years, then such policies may be re-tested in order to determine their MEC status.
In addition, regardless of when a life insurance policy is actually purchased, it could still be tested (or re-tested) if it undergoes a material change in future benefits after June 20th, 1988.
What happens if your policy becomes a MEC?
Once a life insurance policy is classified as a Modified Endowment Contract, it will remain so – even if the policy is later changed, adjusted, or reconfigured as a policy that would not otherwise be considered as a MEC.
When a life insurance policy is considered a Modified Endowment Contract, withdrawals, loans, and / or the use of its cash value as collateral from the policy can result in taxation of a portion – or even all – of the policy’s gains.
Such distributions from a Modified Endowment Contract are treated as coming first from its earnings, and then from its paid-in premiums. In other words, MEC’s distributions are treated as “last in, first out” (LIFO), which means that the non-taxable portion of the cash value (i.e., the policy’s basis) won’t come out until all of the earnings have been accessed.
In addition, because a MEC is considered to be a non-qualified retirement account, in addition to paying regular income tax on the gain that is accessed, any taxable withdrawals, loans, or use of the cash value before the policyholder turns age 59 ½, the funds can also be subject to an additional 10% “early withdrawal” penalty from the IRS.
Is a Modified Endowment Contract Right for You?
Although a MEC isn’t right for everyone, it could be a viable part of your portfolio, especially if you need a single premium life insurance policy. There are strategies to keep your life insurance policy from becoming a MEC. The expertise of your agent will play a huge factor in avoiding a MEC.
If you still have questions about using life insurance as a vehicle to grow funds in a tax-advantaged way and you want to avoid your policy becoming a Modified Endowment Contract, we can help.
We are an independent life insurance agency and can provide you with more details on MECs, as well as help you to quickly and easily compare quotes from the 30+ top-rated insurance carriers we are affiliated with.
At Insurance Geek, we make buying life insurance easy. We’ve already done the shopping for you. So, contact us for more details on how the tax advantages of life insurance could be right for you.