MEC – What is a Modified Endowment Contract

A modified endowment contract (MEC) is the federal government’s classification for a life insurance contract whose premiums have surpassed legislated limits. MECs can have useful tax implications for estate planning, but they can also present a pitfall for life insurance policyholders who find themselves inadvertently holding one. Thus, it is imperative for anyone paying life insurance premiums to understand the history, specifications, upsides and disadvantages of MECs.

The MEC designation was developed by the Internal Revenue Service in 1988 to combat the use of life insurance for tax avoidance purposes. Once life insurance is converted to an MEC, it is not considered a life insurance policy anymore, and the tax rules governing it change as well. The IRS has stipulated three conditions that must be met for a policy to be reclassified as an MEC:

• The policy was issued on or after June 20, 1988. (Policies that are renewed after this date are also eligible to be converted to MEC status.)
• It originally met the industry definition of a life insurance policy.
• The premiums paid into the policy exceed the limit established by the IRS’s “seven-pay test.”

Seven-Pay Test

Established by the Technical and Miscellaneous Revenue Act of 1988 (also known as TAMRA,) the seven-pay test created a specific formula to determine if a life insurance policy needed to become an MEC. The purpose of the test is to determine whether the total amount of the premiums paid into a policy in its first seven years exceeds the amount required for the policy to be paid off within that same seven-year period.

For example, if the IRS has established that a particular policy could be paid in seven years with $30,000, the policyholder can’t pay any more than $4,285 a year (or $357 a month) over that seven-year period. If the premium payments are greater that amount, the policy will automatically be designed a modified endowment contract. Before the passage of TAMRA in 1988, policy owners could accumulate large amounts of cash in a life insurance policy and then withdraw both the interest and the principal, creating a type of tax-free loan. The seven-pay test, and the MEC classification, were measures to keep life insurance from being retooled as a tax shelter.

Tax consequences of an MEC?

For policyholders under 59 ½ years old, the IRS imposes an additional 10 percent penalty for any withdrawal from a modified endowment contract. For example, a policyholder in the 24 percent tax bracket might discover that a withdrawal is subject to total taxes and penalties that take as much as 34 percent of the withdrawal. This deterrent was designed by the IRS to keep policyholders from taking advantage of the tax advantages in a life insurance policy.

Similar to a non-qualified annuity, withdrawals from an MEC are subject to last-in-first-out (LIFO) accounting methodology, so the first withdrawals from the MEC are taxed at the individual’s regular income tax rate. Taxable gains from the endowment are reported before the nontaxable premiums, which could still have some tax benefits if they are withdrawn but only after taxes, and the aforementioned potential extra penalty, are paid on earlier withdrawals.

Cash value policies may keep their first-in-first-out (FIFO) withdrawal status in the eyes of the IRS and avoid being designated as an MEC, but only if they meet specific requirements established by the agency. These criteria, which supersede the seven-way test, assign limits that the premiums of flexible or single-premium policies may not exceed. If a policyholder exceeds the single-premium limit set for a specific policy, sizable IRS penalties can result.

When are MECs beneficial?

Despite the steep penalties and taxes attached to the early withdrawals of MEC funds, death benefits on the contracts are not subject to taxation. Because of this, an MEC can be helpful for estate planning for those who take the time to fully understand it. While they don’t provide the same tax benefits as life insurance, a modified endowment contract can serve as an investment vehicle and provide a reasonable risk-free rate of return. 

Just like whole life or universal life insurance, a modified endowment contract grows in value over time, and investments in a modified endowment contract can grow in a tax-deferred account for the lifetime of the insured individual. This works similarly to an IRA. Once the insured passes away, the account can be passed on to heirs tax-free, assuming the estate is under the limit for estate taxes. Estate taxes start at $11.4 million per individual for 2019.

Some advisors promote MECs as an alternative to annuities, because annuities are subject to tax after the death of the owner. MECs are a hybrid of a traditional investment vehicle and a life insurance policy, since death benefits are still tax-free but they are characterized by disincentives for early withdrawals.

MEC Pro’s and Con’s

For investors looking for a tax-free fund that can be passed down, MECs are one viable option, but there are other investment offerings with the same benefits. As Avo Mavilan, the president of Tailwind Financial Strategies in Houston, told U.S. News and World Report, using an MEC for this purpose is generally only advantageous for those who want to keep money locked away until late in life or those looking to pass on wealth.

“Generally speaking, you see these accounts held by individuals with significant assets, including business owners, those reaching retirement, and already retired,” Mavilian said. “With the need for (funds for) long-term care and chronic illness, a MEC may be a powerful strategy to protect individuals in retirement because of the leverage modern day life insurance policies may provide.”

The disadvantages of an MEC come for those who hope to remove money from the account, especially if they haven’t yet reached the age of 60. Because of the 10 percent penalty and the tax burdens imposed on such a fund by the IRS, it’s wise to be aware of the MEC criteria and take caution to avoid paying excessive premiums. 

Avoiding an unintended MEC

It’s true that some investors decide that an MEC is beneficial as a tax-deferred account for estate planning, but the issue with MECs comes when an insurance policyholder discovers that a policy has been converted to an MEC without their knowledge and against their wishes. Any policy that exceeds the seven-way test or the IRS specifications for a certain policy is automatically converted to an MEC, and once the IRA reclassifies a policy that action cannot be reversed. So what does an astute investor need to do to make sure a life insurance policy retains its intended status?

The first step is to stay up-to-date on the type of policy you are carrying, your reason for maintaining life insurance and the premium limits that could force it into MEC territory. Often, the original purpose for a life insurance policy changes, and a policyholder looking for retirement savings or a legacy fund could serve that purpose with a different financial product. Consumer awareness, especially as laws governing investments change, is the best defense against the unhappy realization that money you have been investing is hindered by burdensome fees or regulations. 

The best insurance agents will keep tabs on a client’s insurance policy to make sure it doesn’t veer close to an MEC classification, and premium payment plans are usually set up to avoid the possibility of a policy becoming an MEC. But as a policyholder you should also educate yourself on the particulars and the pitfalls of an irreversible switch from insurance policy to MEC. If you are not sure about the rules on your policy, contact your policy provider or life insurance agent for more information.

True Value of Modified Endowment Contracts

The use cases for a modified endowment contract can be somewhat complex. That’s why it can be valuable and useful for you to work with an individual or company with in-depth experience with life insurance and MECs. Policyholders are advised to request an annual review from their insurance agent, to make sure they understand the guidelines, benefits and potential downfalls of their policy as they age. A savvy insurance agent or financial advisor can lay out the potential benefits of investing in an MEC, but they may also offer other options to get more value from your life insurance policy, such as a life insurance settlement.

Life settlements can allow a policyholder to get a cash windfall out of an unwanted life insurance policy, yielding cash that can help mitigate the costs of long-term care, medical needs, or retirement expenses. Just as many life insurance policyholders are unaware that they could find themselves inadvertently holding an MEC, many are paying premiums on a life insurance policy that could better serve their needs as a settlement.

For more information about modified endowment contracts or the possibility of selling a policy in a life settlement, visit www.magnalifesettlements.com or schedule a call with one of our settlement experts today.