What Is a Modified Endowment Contract?

A Modified Endowment Contract (MEC) is a specific classification applied to certain life insurance policies under U.S. tax law. This designation prevents individuals from using life insurance primarily as a tax-advantaged investment vehicle rather than for its intended purpose of providing a death benefit. Understanding MEC status is important for policyholders, as it significantly alters the tax treatment of the policy’s cash value and distributions.

Defining a Modified Endowment Contract

A Modified Endowment Contract (MEC) refers to a life insurance policy that has lost some of its traditional tax advantages due to exceeding specific premium limits set by U.S. tax regulations. This reclassification occurs when a policy is “overfunded,” meaning too much premium is paid into it too quickly.

The legislative intent behind the MEC designation stems from the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Before TAMRA, some policyholders were leveraging the tax-deferred growth and tax-free withdrawals of cash value life insurance as a tax shelter. TAMRA was enacted to curb this practice, establishing stricter guidelines to ensure life insurance policies were primarily used for insurance protection. Consequently, an MEC is fundamentally a life insurance policy that has been deemed by the IRS to function more like an investment, thereby losing certain favorable tax treatments.

The 7-Pay Test and Its Role

A life insurance policy becomes a Modified Endowment Contract (MEC) if it fails the “7-pay test,” a mechanism established by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This test measures the cumulative premiums paid into a policy against a cumulative premium limit over the first seven years of the policy’s existence. The purpose of the 7-pay test is to prevent policies from being overfunded relative to their death benefit, ensuring they primarily serve as insurance.

The “7-pay premium” represents the level annual premium that would fully pay up the policy within seven years. The IRS calculates this limit, and if the total premiums paid into a policy at any point during its initial seven years exceed this cumulative 7-pay premium, the policy fails the test. Upon failing the 7-pay test, the policy automatically and permanently becomes an MEC.

A “material change” to a policy can also trigger a new 7-pay test, even after the initial seven-year period. Such changes include increases in the death benefit or adding riders. If a material change occurs, a new seven-year testing period begins, and the policy must again pass the 7-pay test to avoid MEC classification. Once MEC status is attained, it is irreversible, fundamentally altering the policy’s tax characteristics.

Tax Implications of a Modified Endowment Contract

Once a life insurance policy is classified as a Modified Endowment Contract (MEC), its tax treatment for distributions changes significantly. Unlike standard life insurance policies where withdrawals of premiums paid are generally tax-free, MECs are subject to the “Last-In, First-Out” (LIFO) rule for distributions. This means that any withdrawals, loans, or assignments from the policy’s cash value are considered to come from the policy’s accumulated earnings first.

These earnings, when distributed, are subject to ordinary income tax. A 10% penalty tax may apply to the taxable portion of distributions if the policyholder is under age 59½.

There are limited exceptions to the 10% penalty tax, including distributions made due to the policyholder’s death or disability. Despite these less favorable tax rules for cash value distributions, the death benefit paid to beneficiaries from an MEC generally remains income tax-free, consistent with non-MEC life insurance policies.