What is a Modified Endowment Contract?
A Modified Endowment Contract (MEC) is a life insurance policy that fails the 7-pay test established by the Tax and Miscellaneous Revenue Act of 1988 (TAMRA). Failure of this test reclassified the life insurance policy, which comes with several changes to the taxation of the insurance contract.
It's important to understand that while they are different from ordinary life insurance policies under U.S. Federal Tax Law, MEC's are still a form of insurance contracts. They continue to pay a death benefit. They will continue to accumulate cash value. If the policy is still within its premium payment period, policyholders will continue to pay premiums to the policy.
You should also know that the Modified Endowment Contract is not the same as a traditional life insurance endowment contract. The latter being an insurance policy rendered obsolete in the U.S. during the adoption of Tax Code during the early 1980s that was a precursor to TAMRA.
Understanding the 7 Pay Test and Why it Exists
The 7-pay test is a premium limit placed on a life insurance policy based on the total death benefit of the policy. This means the 7-pay limit is tied to the prevailing death benefit of a cash value life insurance policy.
The specific MEC rule limits the sum of the net level premiums from exceeding the amount needed to guarantee all of the future benefits of the policy paid over seven contract years. This essentially means that the 7-pay limit prevents a life insurance policy from becoming paid-up prior to policy year 7.
So for example, let's assume that you buy a life insurance policy that has a 7-pay premium of $50,000. The specific calculation that arrived at this $50,000 involved information regarding the death benefit amount, the guaranteed accumulation rate, and mortality expenses of the policy. Note that I left out administrative expenses. Insurers can only assume the raw insurance cost of providing a death benefit when it comes to the 7-pay test; they cannot include additional expenses associated with normal business operations.
So long as your annual premium does not exceed $50,000 in the first seven contract years, you will not violate the 7-pay test and create a Modified Endowment Contract. This amount is cumulative, so if you make a premium payment of $25,000 in contract year one, you can technically make a payment of up to $75,000 in year two without creating a MEC.
It's also important to know that because the MEC rules prevent guaranteed paid-up policies prior to year seven, single-premium life insurance policies automatically become Modified Endowment Contracts. So if you own a single-premium policy, you also own a MEC.
Understanding why the MEC rules exist requires us to go back to the 1970's when a pivotal change in the life insurance industry took place. Up to this point, very few life insurance policies offered policyholders the option to pay considerably more premiums than the required premium for a given death benefit.
But during the 1970s, life insurance companies came up with a new innovation, universal life insurance. This new product boasted several features never before seen, one of which was a flexible premium that could, in theory, be as high as the policy owner wished. This opened the door to exploit the very tax favorable aspect of life insurance cash value, and it was especially salient given the high-income tax rates that prevailed at the time.
Universal life insurance created a mechanism for Americans (specifically wealthy Americans) to house substantial cash in life insurance and use its tax-avoiding nature to prevent significant tax payments to the Federal Government. It was a tax-shelter play that didn't require complicated off-shore bank accounts.
During the early years of universal life insurance, Americans could literally buy a policy with as little death benefit as the life insurance company allowed, make a premium payment many times larger than the death benefit, and secure a tax-free account with almost no insurance expenses. This, of course, was not the intention of life insurance, and Congress sought to close the loophole. It first acted in the early 80's with rules that established what was and what was not a life insurance contract. Congress then revisited these rules in the later 80's to put additional requirements in place in order to maintain bona-fide life insurance status. This late 80's revision established the 7-pay test and Modified Endowment Contracts, under TAMRA.
So the Modified Endowment Contract exists as a means to prevent the use of life insurance purely as a tax-shelter. While people do still today use cash value life insurance as a means to accumulate tax-deferred and potentially tax-free wealth, MEC rules make it more complicated and less appealing than it once was.
Who is Responsible for Ensuring Compliance with Federal Tax Law Limits?
The insurance company holds the responsibility of checking a policy for compliance with the 7-pay test. Just about all life insurers perform the calculation whenever receiving a premium payment on a cash value life insurance policy. If the carrier deems all or a portion of the payment excess premiums per 7-pay limits, it will immediately notify the policyholder that he/she violated the 7-pay limit on his/her policy.
Insurance carriers report MEC classification for all insurance policies that fail the test to the IRS.
Material Change: MEC Violation after 7 Years
While some people believe that Modified Endowment Contracts only happen in the case of a single premium life insurance policy or violation of the 7-pay test within the first 7 policy years, this is an incorrect understanding of the rules.
Both whole life insurance and universal life insurance policies can violate the MEC test and become Modified Endowment Contracts in policy years 8+. This can happen whenever the policy undergoes a material change.
Generally speaking, a material change occurs whenever a policyholder adds a feature to a life insurance policy or changes the insured of the policy. With each material change, a new 7-year clock begins.
Increasing the death benefit counts as an additional feature. Many cash value policies use features that create increasing death benefits, which causes a continuation of the MEC 7 year period. For this reason, whole life and universal life policyholders who use policies that have an increasing death benefit, will have policies subject to premium limits imposed by the Modified Endowment Contract rules for an indefinite period.
What Happens When a Policy Becomes a Modified Endowment Contract?
If a life insurance policy becomes a Modified Endowment Contract, the taxation rules of the cash value held in the policy will dramatically change.
These rule changes have almost no impact on the death benefit of the policy. MEC's will still pay an income tax-free death benefit to the beneficiary of the policy.
Tax Consequences of MEC Status
A life insurance contract that fails the 7-pay test and becomes a modified endowment contract loses several tax benefits concerning the cash value of the contract.
Instead of using the accounting principle first-in first-out (FIFO), a MEC will use last-in last-out (LIFO). This means when a policyholder removes money from the policy, he/she must first take out any gains achieved by the contract before taking non-taxable cost basis. This rule on withdrawals is true for both a partial surrender and policy loans. Making a collateral assignment with a MEC (i.e. using the contract's cash value as assets pledged for a bank loan) also counts as a taxable distribution.
The contract owner also faces a similar penalty found on retirement accounts where taking money from the contract prior to age 59.5 incurs an early distribution excise tax of 10%.
It's important to understand that ALL distributions from a MEC count as taxable income provided there still gain in the policy. There is a subtle, but important technical consequence of taking policy loans against a MEC. If the MEC policyholder chooses to let loan interest add to the cumulative amount of the loan each year (a very common practice for loans taken against traditional life insurance policies) this accumulated loan interest will also count as a distribution from the MEC and potentially create additional taxable income.
For example, assume that you own a contract that is under MEC status. The policy has $100,000 in cash value and you paid a total of $50,000 in premiums to the policy. You decide to take a $10,000 loan against the policy. Annual loan interest on loans for this policy is 5%.
This $10,000 loan will increase your taxable income for the year by $10,000. This happens because you have $50,000 in gains in the policy and you must remove this first before you can touch the $50,000 basis you have by virtue of paying premiums. Over the course of one year after taking the loan, and assuming you make no loan repayments, you'll accumulate a total of $500 in loan interest.
Just like any policy loan you'll have the option to either pay this $500 or let it add to your current loan balance. If you choose to add the $500 to your loan balance, this creates another $500 distribution from the policy, which adds an additional $500 of taxable income to you.
One year later, assuming you make no repayments to the loan accumulated balance, you'll have accrued another $525 of loan interest. If you again choose to add this to the loan balance, you'll add $525 of taxable income that year.
This loan interest implication is a potentially small, but oftentimes annoying implication of owning a Modified Endowment Contract.
The last important tax consequence to understand about MEC's is that you cannot exchange a policy under MEC status to a new life insurance policy without immediately creating a new MEC. This rule exists to prevent people from intentionally violating the 7-pay test and then buying a new life insurance policy via the 1035 exchange tax provision to avoid the consequences of violating the test. So if your current policy is a MEC and you transfer it to a new policy via 1035 exchange, that new policy is automatically a MEC.
While MEC's dramatically change the tax consequences of a life insurance contract's cash value, they do nothing to the taxable rules regarding the death benefit. This means a Modified Endowment Contract will still pay a death benefit that your beneficiary received income tax-free.
Are They Ever a Good Thing?
While most people hold a very negative view about Modified Endowment Contracts, there are some people who intentionally create them. The vast majority of Americans are probably best off seeking to avoid MEC status on their life insurance policies. But there are some situations that could use a MEC with positive results.
The taxability of a MEC is similar to non-qualified annuities. Though a MEC doesn't necessarily come with the guaranteed income feature annuities can provide, there are times people use them in place of standard annuities when they think the MEC will provide a higher rate of return on cash value or because they want the additional death benefit it creates.
A modified endowment contract can also, at times, work well as a tool for estate planning purposes. Because MEC status has virtually no negative tax consequences on the death benefit, some people use them as a way to provide liquidity at death or to augment the value of their savings they intend to pass on to loved ones.
There are several considerations to ponder when a MEC option is on the table, and in a majority of cases, it probably won't be the best one. However, you shouldn't immediately rule it out just because most people say MEC's are bad.
Can a Modified Endowment Contract be Reversed?
Yes there is a process to reverse MEC status if you discover you violated the 7-pay test. A lot of insurance companies make this process almost automatic in the sense that they will attempt to stop you from doing it before you technically achieve violation.
As mentioned already, life insurers check life insurance policies for compliance with the 7-pay test with every premium received. If your payment appears to violate the test, they will notify you in an attempt to prevent you from accidentally creating a Modified Endowment Contract. But even if you ignore this warning, you technically have up to 60 days after the end of the policy year in which the violation took place to request the insurance company refund you the premium amount that caused the violation.
What is more, there is a process the Tax Code spells out to reverse MEC status for a policy that exceeds this timeline (i.e. 60 days after the close of the anniversary date in which violation took place), but understand that insurers aren't always willing to undertake it.
The law does permit an insurer to undergo a lengthy process of reversing MEC status and paying a small fee to reverse the classification. The law does permit this, but don't expect your life insurer to volunteer this service if you cause your policy to become a Modified Endowment Contract.