Modified Endowment Contract: MEC Should You Be Worried?

Anyone who has looked into cash value life insurance has no doubt run into the term Modified Endowment Contract(or MEC).  Those with flexible premium policies, may have noticed a portion on their statements that stipulate whether or not the contract is a Modified Endowment Contract or not.

And you may have even seen numbers that reflect the amount of money that can go into the policy before it turns into a MEC. What does all this mean and why cares?  We’ll explain MEC’s in their entirety today.

First a Little HiModified Endowment Contractstory

Modified Endowment Contracts were created by the Technical and Miscellaneous Revenue Act of 1988 as yet one more way to quell the use of cash value life insurance contracts as a tax shelter (The Tax Equity and Fiscal Responsibility Act of 1982 and the Deficit Reduction Act of 1984 were two prior pieces of legislation that affected life insurance contracts with non-forfeiture–i.e. cash value–provisions).

Since life insurance cash values grow tax free and can be accessed without being realized as income for income tax purposes, TAMRA posed a new hurdle for those seeking to place large amounts of cash into life insurance policies solely for the purpose of accumulating cash (i.e. with no real desire for death benefit).

TAMRA did this by creating what is known as the 7 pay test, which is a maximum premium amount based on the assumed cash values those premiums would create relative to the death benefit on the contract.  The do not cross line–is the amount needed to make the contract guaranteed paid up within 7 years.

After 7 Years…

A common mistake agents (and some life insurance company home office employees) make is assuming that after 7 years there is no more need to worry about the reclassification of the contract as a Modified Endowment Contract.  This is incorrect.  Anytime the contract undergoes a material change, the 7 Pay Test clock is reset.  Material changes are defined as:

  • Any increase in the death benefit
  • Any change in a benefit under the contract (i.e. addition of a rider)

So, if one is constantly placing Paid-up Additions into a contract, the 7 Pay Test is constantly resetting.

Why Avoidance is Generally Desired

If the contract is reclassified as a modified endowment contract the following new rules apply:

  • Withdrawals are no longer taken on a First In First Out (FIFO) basis but rather a Last In Last Out (LIFO) basis.  Meaning any (taxable) gain in the policy will be withdrawn before (non-taxable) basis is withdrawn (like a standard annuity withdrawal)
  • Loans are now realized as ordinary income to the owner and taxable
  • Withdrawals and loans are subject to the same early withdrawal penalty found on retirement vehicles, meaning loans or withdrawals prior to age 59.5 incur a 10% penalty tax (except in cases making use of a 72(v) distribution).

With this, it’s typically advisable to avoid MEC status, however there are times when intentionally setting a policy up to become a MEC is completely reasonable.  One such situations has already been discussed on the Insurance Pro Blog.

What Happens if I Violate the 7 Pay Test and How will I Know?

Insurance companies typically perform MEC testing once a month (or whenever premiums are paid to the contract).  In fact, some of the limitations companies place on the frequency of placing Paid-up Additions into a contract have to do with simplifying their MEC testing requirements.

If the 7 Pay Test is violated, you’ll have 60 days after the close of the contract year to reverse the situation by taking the money back out.  If you fail to do so the contract will be reclassified as a MEC, which is irrevocable.

How irrevocable?  We mean irrevocable.

Once a contract has been reclassified as a MEC, that status follows it everywhere.  If you exchange your MEC for a new life policy through a 1035 exchange, the newly issued contract will be classified as a MEC even if it does not violate the 7 Pay Test.  The only way to start over is to truly start over by beginning a new policy, that is not directly funded by the old one.

How Do I Know if My Contract is Designed Correctly to Avoid a MEC?

All cash value life insurance contracts must be sold with an NAIC compliant illustration.  That illustration (the several pages filled with ledgers and information about the policy and it’s riders) will also detail if the designed policy will become a modified endowment contract and what years that would be projected to happen.

On top of this, all illustrations will speak specifically to certain tax implications as detailed by IRC 7702, and if the calculation for the illustration based on the inputs does not appear to create a MEC, the illustration will state something to this effect within this section.

Also, the illustration will usually (but not always) stipulate the 7 Pay Premium (the max premium before failure of the 7 Pay Test).  So you can compare the planned outlay against the 7 Pay Premium.  You can also use this as a guide to determine how much additional money you are likely able to place into the contract before it would turn into a MEC.

It’s important to note that this number is an estimate.  Higher dividends than assumed (for example) could reduce the amount you can contribute, but if you can get more for putting in less, that’s not such a bad thing.

Whole Life Blending: How To Get Higher MEC Limits

A topic I’ve discussed in the past is how to blend a whole life policy to increase the 7 Pay Test with minimal cost in to increase the amount of extra money that can go into the policy.   Intuitively, what happens is the increased death benefit leaves more room for money to sit inside the policy.

Also, I would be remiss not to mention that this is an available feature on some Universal Life Contracts, but generally by design blending is better left to whole life contracts, while max funded to death benefit making use the Guide Line Premium Test is the way to approach universal life.

Blending a universal life contract can sometimes create higher mortality expenses later on that are counter productive, and the blend is traditionally not needed to fill the policy with ample cash.

You could also potentially take advantage of a temporary term rider (this is how some companies blend their whole life contracts).  These riders are either short term level term policies or annually renewable term.  It’s no at optimal as companies that simply add a term component to the policy (Note: they’ll all refer to the term portion as a rider, the question is more in how long you can contractually keep the term rider in place).

And that’s really about it.

On one final note, don’t buy the warnings you’ll sometimes find out there warning about the MEC’s sneaking up from behind and surprising you with an unpleasant tax situation.  There’s ample notice of the reclassification of MEC status by any insurance company.

Of course, this also emphasizes the importance of working with competent agents.  It is, in reality, somewhat difficult to accidentally create a Modified Endowment Contract, unless someone really doesn’t know what he or she is doing.

2 Responses to “Modified Endowment Contract: MEC Should You Be Worried?”

  1. Jeff Hexter says:

    I had a thought about MEC/10-pay WL/SPWL the other night…

    Do municipalities (cities, townships, counties, etc) pay income taxes on their investment gains?

    If not, would they be subject to the penalties of a MEC?

    If they are not subject to the penalties of a MEC, why not create MECs to help finance government operations? The death benefit would possibly replace the lost inheritance taxes, and the return on taxpayer dollars would be significantly better than bank interest rates.

    Call it GOLI.

    Is this done? Can this be done?

    • Brandon Roberts says:


      As a general rule, no municipalities do not pay taxes.

      But there are a few issues that would make this somewhat tricky.

      1. There are some restrictions placed on the amount of money a local government can “save” if it’s using funds that were collected from tax payers.

      2. The purchase would need to be made by the governing body of the municipality (city council, selectboard, etc.). So we’re asking a legislative or pseudo-legistlative body to approve a selective employee retirement benefit in the name of creating deeper pockets for the municipality. Good luck getting the average councilperson or selectperson to wrap his or her head around the idea.

      It does have a lot of attractive benefits, but it’s certainly impeded by politics. Though it’s not unheard of in certain other facets of local and state government. We covered some time ago the use of life insurance as a personal benefit to Judges in Louisiana. You can see from that example that while the idea was perfectly within the realm of doable as a benefit to the individual working as a judge, it carries a certain connotation that some find politically thorny.

Leave a Reply