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What is a modified endowment contract?
A modified endowment contract, or MEC, is a life insurance policy that took in more premium in its first seven years than the IRS allows. The death benefit is generally still income tax free. But loans and withdrawals get taxed as income first, plus a 10 percent penalty before age 59 and a half. Once a policy becomes a MEC, it stays one.
A MEC is a life insurance policy the IRS decided was funded too fast.
Cash value inside a life insurance policy grows without yearly tax, and a normal policy lets you borrow against it without paying tax on the loan. In the 1980s people noticed that. They started dropping large single payments into policies that were really savings accounts with a small death benefit attached.
Congress answered in 1988. It set a limit on how fast you can pay money into a policy. Go over it, and the policy gets relabeled a modified endowment contract. It is still life insurance. It just loses the tax treatment on money you take out while you are alive.
Quick note on who is talking. opfinances.com is a licensed insurance agency. We are not a financial advisor, not a fiduciary, and not a tax professional. This is general education. Run your own situation past a CPA.
The seven pay test sets the ceiling, and the insurer does the math.
The limit is called the seven pay test. The insurer works out what level yearly premium would fully pay up the policy in seven years. If the total you actually pay in at any point during those first seven years is more than that running limit, the policy fails the test.
The limit depends on the death benefit, your age and your health rating. A bigger death benefit means a bigger limit. That is the lever every overfunded policy design pulls.
You do not have to calculate this yourself. The insurer tracks it on every policy. If a payment would push you over, most insurers will refuse it or send the excess back. The tax rules give them until 60 days after the end of that contract year to refund it with interest, and a refund in time keeps the policy from becoming a MEC.
Once it is a MEC, loans get taxed like income first.
In a normal policy, withdrawals come out of what you paid in first, so they are not taxed until you take out more than your premiums. Loans are not taxed at all while the policy stays in force.
A MEC flips that. Any money you take out, loans included, counts as gain first and is taxed as ordinary income until the gain is used up. If you are under 59 and a half, there is usually an extra 10 percent penalty on top. Pledging the policy as collateral for a bank loan counts as taking money out too.
Here is an illustrative example. Say you paid 200,000 into a MEC and the cash value is now 260,000, so you have a 60,000 gain. You borrow 50,000. In a normal policy that loan creates no tax. In a MEC the full 50,000 is taxable income that year, and at age 55 another 5,000 penalty sits on top.
The label is permanent, and a change years later can trigger it.
Once a policy becomes a MEC, it stays one. There is no paying it back down to fix it. If you exchange a MEC for a new policy, the new one inherits the label.
The trap people miss is the change made later. Cutting the death benefit during the first seven years recalculates the limit as if the lower amount had been there from day one, and premiums you already paid can suddenly be over the line. Some bigger changes to a policy start a fresh seven year test. Ask before you reduce or add coverage, not after.
For infinite banking a MEC breaks the plan, but for some people it is fine.
Infinite banking runs on borrowing from your own policy without a tax bill. A MEC takes that away, so these policies are designed to stay just under the limit. Often that means adding a term rider to raise the death benefit, and the limit with it, so more cash can go in. A design funded right up to the line leaves no room for a missed change or a reduced benefit later. Ask how close yours runs.
A MEC is not automatically a mistake, though. If you never plan to touch the cash and want the money to pass to your family, a MEC still grows without yearly tax, and the death benefit is generally still income tax free. Any guarantee in any of these policies depends on the claims paying ability of the insurer. The MEC rules only bite when you take money out while you are alive.
Before you decide
Questions worth asking.
What is the seven pay limit on this policy each year, and how close does this illustration fund it to that line?
Is this policy a MEC today, and will you show me that in writing?
If I lower the death benefit in the first seven years, does this policy become a MEC?
If I send a payment that goes over the limit, do you refuse it or refund it, and how would I find out?
How much of this design is a term rider added to raise the limit, and what does that rider cost me each year?
If I add coverage or change this policy later, does the seven pay test start over?
Related
Is a modified endowment contract bad?
Not always. It hurts if you plan to borrow or withdraw while you are alive, because that money is taxed as gain first and can carry a 10 percent penalty before age 59 and a half. If you never plan to touch the cash, the death benefit is generally still income tax free.
Can a MEC be changed back into a regular life insurance policy?
Generally no. Once a policy becomes a MEC, it stays one, and a policy you exchange it for inherits the label. The only fix is before it happens: if the insurer refunds the excess premium with interest within 60 days after the end of that contract year, the policy does not become a MEC.
Is the death benefit of a MEC taxable?
The death benefit of a MEC is generally income tax free to the beneficiaries, the same as a regular life insurance policy. The MEC rules change how money you take out while you are alive is taxed, not what your beneficiaries receive.
How do I know if my life insurance policy is a MEC?
Ask the insurer. They track the seven pay limit on every policy and can confirm in writing whether yours is a MEC and how much room is left under the limit. Some annual statements show it too.
Where this fits.
This question sits inside a bigger one. Infinite Banking walks through the whole decision rather than this one piece of it.
On Point Finances is a licensed insurance agency, not a tax, legal, or investment adviser. This page is general education, not a recommendation, and reading it does not create a client relationship.