Anyone who has looked into cash value life insurance has probably come across the term Modified Endowment Contract (MEC). Those with flexible premium policies may have noticed a portion of their statements that stipulate whether or not the contract is a Modified Endowment Contract.
You may have even seen numbers indicating the amount of money that can go into a policy before it turns into an MEC. What does it mean, and why do we care? We’ll explain that and more today as we cover MECs in their entirety.
First a Little History
Modified Endowment Contracts were created by the Technical and Miscellaneous Revenue Act of 1988 as yet one more way of quelling the use of cash value life insurance 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 – that is, 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 (those 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 seven years.
After 7 Years…
A common mistake agents (and some life insurance company home office employees) make is assuming that after seven years, there is no more need to worry about the reclassification of the contract as a Modified Endowment Contract. This is incorrect. Any time the contract undergoes a material change, the 7 Pay Test clock is reset. Material changes include the following:
- Any increase in the death benefit
- Any change in a benefit under the contract (e.g., the addition of a rider)
So, if one is constantly placing paid-up additions into a contract, the 7 Pay Test is constantly resetting.
Why You Might Want To Avoid MEC's
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. So, any (taxable) gain in the policy will be withdrawn before the basis (non-taxable) is withdrawn (such as a standard annuity withdrawal).
- Loans are now recognized as ordinary income to the owner and are 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).
Considering, it’s typically advisable to avoid MEC status; however, there are times when intentionally setting a policy up to become an MEC is completely reasonable. One such situation has already been discussed on our beloved Insurance Pro Blog.
How Will I Know I Violated The 7 Pay Test and What Happens If I Do?
Insurance companies typically perform MEC testing once a month (or whenever premiums are paid to the contract). In fact, some of the limitations companies put 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 an MEC, which is irrevocable.
How irrevocable? Totally irrevocable.
Once a contract has been reclassified as an 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 an 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 Prevent My Policy From Becoming an 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 whether the designed policy will become a Modified Endowment Contract and project which years that might 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 an MEC, the illustration will state something to that effect.
Also, the illustration will usually – but not always – stipulate the 7 Pay Premium (the max premium before the 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 can place into the contract before it turns into an MEC.
It’s important to note that this number is an estimate. For example, earning higher dividends than assumed could reduce the amount you can contribute, but if you can get more for putting in less, that’s not such a bad thing.
How To Get Higher MEC Limits With Whole Life Blending
We’ve discussed how to blend a whole life policy to increase the 7 Pay Test with minimal cost and thereby increase the amount of extra money that can go into the policy. 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, blending by design is better left to whole life contracts. The best approach to universal life is max-funded to death benefit making use of the Guideline Premium Test.
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 or annually renewable term policies. It’s not optimal as companies simply add a term component to the policy (they’ll all refer to the term portion as a rider, but the question is how long you can contractually keep it in place).
And, that’s about it.
On one final note, don’t buy the warnings you’ll sometimes hear about MECs sneaking up from behind and surprising you with an unpleasant tax situation. All insurance companies will give ample notice of any reclassification of MEC status.
Of course, this also emphasizes the importance of working with competent agents. It is actually somewhat difficult to accidentally create a Modified Endowment Contract, unless the agent really doesn’t know what he or she is doing. If you’d like to talk to someone who does, you know where to find us.