Modified Endowment Contract: Pro Blog Style

Modified Endowment Contract is frequently known as a condition where an insurance contract becomes “paid up” within 7 years. That's an okay understanding of a basic principle (it served me well for about 6 months and insured I didn't do anything really stupid when I was armed and dangerous as a new agent), but there's more to MEC's than just not making it paid up within 7 years.

More than You ever wanted to Know

In order to understand the technical nature of Modified Endowment Contracts, it's helpful to understand how a life insurance contract is built. Without getting really lost in the details, it's important to understand the following:

Life insurance pricing starts with the Net Single Premium

And how does one derive a Net Single Premium? With the following equation:


Modified Endowment Contract

This very simple equation tells us to sum the results of the right hand formula for each year.  So we take the death benefitprobability of death x an interest adjustment and we sum all of those results for each year to derive the Net Single Premium.

We then take the Net Single Premium and divide by the Present Value of a Life Annuity Due for $1 for the duration of the contract. This will give us the annual level premium (aka the Net Level Premium) of the insurance contract. And that is a basic introduction to life insurance premium pricing. Keep in mind that we are talking net premiums (i.e. does not include expense loading, this will become very important in just a second).

So, the MEC test (typically referred to as the 7-pay test) stipulates that incoming premiums cannot exceed the premiums that would total the net level premiums that would be needed for a 7 pay policy.  In other words, the premiums that would be needed to establish a cash surrender value to ensure all of the policy's benefits within a 7 year period.

Now, notice the word NET.

How is a “net premium” defined?

Net premium subtracts the loading expenses that insurance companies include to cover their operating expenses.  Because the MEC test focuses on the net premiums there is no adjustment for the fact that gross premiums are how you and I pay out insurance premiums.  This means our restrictions concerning the amount of money that can be paid into our policies is further restricted by the fact that the number used to derive it, doesn't care about the fact that a portion of our premium goes towards the CEO's salary (i.e. if the 7-pay test were to instead use gross premiums under the same assumptions, we'd be able to place more money into the policy).

After 7 Years…

A place that some people tend to get into trouble is in the assumption concerning what happens after 7 years.  Intuitively it makes sense that after 7 years we're free to do whatever we want with our policy.

Alas, the IRS wasn't that dumb.

If at  anytime the policy undergoes what is known as a material change, the 7 pay test will reset and begin ticking again.  What is a material change?  Essentially, any increase in any benefit under the contract.  This includes increases to the death benefit by larger than necessary premiums (i.e. paid-up addition payments for whole life, and extra premium under a universal life contract).

Note however that this does not include paid-up additions purchased by dividends or increases in death benefit created by credited interest.

The big takeaway here is that heavily over-funded life insurance contracts will be in an a state of perpetual 7-pay reset so long as premiums beyond the stated required premium for whole life and/or large enough to create a death benefit increase for universal life are made to the contract.

So, to ensure absolute clarity, after 7 years, the 7 pay test may still be a concern.  And, it is certainly very incorrect to assume that after 7 years, you could dump as much money as your heart desired into a life insurance policy without having to worry about modified endowment contract re-classification.

Reduction in Benefits

It should be noted that reductions in benefits are not normally viewed as a material change.  This means that a reduction in the death benefit would not trigger a reset of the 7-pay Test.   However, its should also be noted, that any reduction in benefits during the 7-pay Test period will cause a recalculation of the the 7-pay premium as if the reduction had been established at the outset.

An example will ensure clarity:

Let's say Sally has a life insurance contract with an annual 7-pay Premium of $15,000.  In year four Sally decides to reduce her death benefit and this reduction lowers were 7-pay Premium to $10,000.  If Sally has been paying the full 7-pay Premium since year 1, her contract would violate the 7-pay Test if she decides to go through with the reduction in death benefit as she has paid too much in premiums years one through three.

Accidental MEC?

While some people have alluded to the idea of accidentally turning your life insurance contract into a modified endowment contract through over-payment, don't fall for the sensationalism.

Truth is, you'd be quite hard-pressed to do this and not know about it.  MEC testing is performed typically with each premium received.  If violation occurs the insurance company will send ample notice, and the premiums that made the violation need to be returned within 60 days after the close of the policy year in which the violation occurred.  The insurance company does need the contract owner's written consent to refund the premiums.

In fact the IRS has put in place rules for insurance companies to follow to correct “accidental 7-pay Test failure.”

This requires what can amount to some substantial administrative work on the behalf of the insurance company and it also requires the insurance company to pay a penalty tax (known as a “Toll Charge” to the IRS).  Going through these paces, however, can reverse MEC status.  It only applies to what the IRS labels “non-egregious” violations.

If you're wondering what the IRS considers non-egregious there's some black, white, and grey over this.  The big time can't-be-changed situations are single premium products or situations and policies intentionally made paid up prior to year seven.  There is not a lot of guidance, however, on where paying up to the 7 pay premium and accidentally going over places someone.

Consequences of Violation

If the a life insurance contact becomes a Modified Endowment Contract the following rules apply:

  • Distributions from surrenders are no longer First In First Out (FIFO) but Last In Last Out (LIFO) meaning taxable gain will be surrendered first (and the policy owner will recognize the gain as ordinary income)
  • Loans will be treated as surrenders with the same LIFO distributions (i.e. they become taxable as ordinary income to the extent there is a gain removed from the policy)
  • Distribution rules that apply to tax deferred retirement accounts will be applied to the contract, meaning money withdrawn prior to age 59.5 of the contract owner will be subject to a 10% early withdrawal penalty provided the owner is not making use of a 72(v) distribution

Are MEC's Bad?

We've addressed this before.  While they certainly aren't coveted in a lot of situations, there's no need to avoid them simply for the sake of avoiding them.  While it's prudent to build a plan that seeks non-MEC status in most cases, there are times when intentionally turning a life insurance contract into a modified endowment contract makes perfect sense.

2 Responses to “Modified Endowment Contract: Pro Blog Style”

  1. Scott Scarborough says:

    Hello Brandon,

    I am reading this several years after the fact so I don’t know if you will get this message. I have several questions. 1) Is the “interest adjustment” term in the above equation a discount for the future value of money? 2) What does the $1 mean for the Annuity, I don’t understand that. 3) Why wouldn’t some insurance company be upfront about the Net premium so the customer could get a better deal? If they broke it out as the Net premium + a fee to the Insurance company wouldn’t the IRS have to calculate the MEC test based on what the Insurance company calls the premium?

    • Brandon Roberts says:

      Hi Scott,

      1. The interest adjustment merely assumes that premiums are paid in the beginning of the period and will earn some level of interest. It’s for this reason–also–that a modal charge is applied to life and other types of insurance policies.

      2. This is simply what the insurance industry and financial industry calls a time value of money factor to clarify if they are factoring interest into the calculation at the beginning or the end of the period.

      3. They can’t, the MEC calculation only accounts for the net premium, but there is no way to cut out of the gross premium. And the insurer cannot inflate the net premium since that is both tightly scrutinized by the DOI (by law they can’t necessarily profit from collection of the net premium) and would also greatly inflate reserve requirements.

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