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Modified Endowment Contract (MEC) | The Ins and Outs

modified endowment contract
Insurance Quotes 2 Day Team

Written By Doug Mitchell

Doug Mitchell, CLU holds a BA degree in Finance from Auburn University as well as having obtained a Chartered Life Underwriter (CLU) designation from The American College in Bryn Mahr, PA.  Doug has spent close to 30 years in the insurance and financial planning industry and has held licenses to sell securities, long-term care insurance, health.  Doug is also a financial blogger addressing the topics of life insurance, annuities and retirement income planning.

Holly Mitchell  &

Holly Mitchell’s background in life insurance insurance goes back to 1985 when she worked for her father who was a New York Life agent. Holly has a marketing degree from Auburn University and has had a life insurance license since 2008. In addition to advising life insurance for customers all around the country, Holly is our website fact checker.

Rob Pinner   &

Rob Pinner is the founder and CEO of Pinner Financial Services servicing all 50 states. Rob started his insurance career in 2002.

Louis LaBash

Results-driven and innovative life insurance professional with 30 plus years of life insurance industry sales and marketing experience. Recognized as a pioneer in the field, leveraging phone and internet channels to exceed personal sales of over $100 million during the first decade of the 21st century. Creator of a highly effective intuitive IUL life insurance sales software that facilitated the sale of millions of dollars of indexed universal policies by numerous life insurance agents. Proven track record as a Managing General Agent (MGA), Life Agent, IUL Life Insurance Sales Software developer, and leading-edge creator of insurance marketing tools, educational content, and delivery systems.

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In the many articles, we have provided regarding Indexed Universal Life Insurance, we have on many occasions mentioned the modified endowment contract but have not had an in-depth discussion.

In this article, we are going to drill-down into the modified endowment contract (MEC) and discuss the ins and outs so that policyholders will understand whether a MEC is a good thing or bad thing for their individual circumstances. MEC insurance might seem confusing, but it’s really quite simple.

The good news is that there are no changes in the Modified Endowment Contract status in 2022.

What is a Modified Endowment Contract?

what is a modified endowment contract

 

The term modified endowment contract (MEC) designates that the funding of a life insurance contract has surpassed the limits set according to federal tax law. This means that the IRS no longer considers the contract to be a life insurance contract. Sometimes this action is referred to as modified endowment contract life insurance.

This classification was implemented by the IRS to discourage the use of life insurance products to avoid paying taxes. There are three criteria set by the IRS that will change the classification of a life insurance contract to a modified endowment contract (MEC):

  1. The policy was issued on or after June 21, 1988.
  2. The policy fails to meet the Technical and Miscellaneous Revenue Act of 1988 7-pay test (also known as TAMRA)
  3. The policy is received in exchange for a policy that is already a MEC.

What the heck is TAMRA?

In simple terms, TAMRA of 1988 created the modified endowment contract (MEC). Until this law was passed, withdrawals from a cash value insurance policy were taxed based on first-in-first-out.

This meant that the premium paid into the contract was always withdrawn before any earnings. Since the premium was considered a return of principal in the contract, these withdrawals were considered non-taxable by the IRS.

Knowing that the policyholder would be tempted to stuff their insurance policies with premium in order to avoid paying taxes on withdrawals, tax-hungry legislators instituted rules that would combat policyholders from creating a large-scale tax shelter.

The TAMRA of 1988 placed a limit on the amount of premium policyholders could pay into a life insurance contract and still qualify for first-in-first-out treatment (tax-free).

Effectively, any cash-value life insurance contract that was issued on or after June 20, 1988, that receives premium payments over and above the limits set by TAMRA would be designated as a modified endowment contract (life insurance MEC) and thus lose the FIFO tax status.

LIFO versus FIFO

Simply put, when a cash-value life insurance policy is designated as a modified endowment contract (MEC) the withdrawals are changed to last-in-first-out instead of first-in-first-out which means your withdrawals include interest earned on the premiums and those gains will be taxable. In essence, your cash value life insurance has become a non-qualified annuity.

There is also another issue to deal with if your life insurance contract becomes a MEC. Just like with an annuity, if you withdraw funds prior to 59 ½ your withdrawals will be subject to a 10% penalty and treated as income.

For policyholders whose intentions are to use their cash value life insurance as a LIRP in order to avoid paying taxes on withdrawals, the MEC should be avoided at all costs. This is when having an experienced and reputable insurance professional to set up your insurance policy is critical.

What is a MEC? Is it Good Thing or a Bad Thing?

 

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For most owners of cash-value life insurance, they know in advance whether a MEC insurance is a good thing. There are certain circumstances when a MEC life insurance policy provides an excellent solution for the defined needs of the policyholder. Here are four circumstances in no intentional order where a MEC would be a good solution.

  • Estate Planning Tool – If the life insurance applicant wants an estate planning tool that will protect the estate be passed on to their heirs and the policyholder will only be concerned about the non-taxable death benefit, then a MEC is a good solution since there are no concerns about withdrawals.
  • College Planning – For a parent or parents who are applying for federal aid under FAFSA, there are designated assets that will not be counted against the family when they preparing to pay for college. Assets in a life insurance policy or annuity are exempt under FAFSA. This means that assets can be moved into a MEC in order not to be counted in the Financial Aid Formula. By using this strategy, the applicant will have created a rather large death benefit while preserving financial assets and therefore able to qualify for more financial aid. If you decide to cancel the policy later, the impact of a surrender charge is minimal when you consider the amount of additional aid you would receive.
  • The MEC becomes an Annuity – Whenever a life insurance policy is intentionally overfunded to become a MEC, it essentially becomes an annuity with a large death benefit that is paid to your beneficiary tax-free so if your question becomes “is a modified endowment contract death benefit taxable to the beneficiary”, there’s nothing to worry about in that regard.

Certainly, having a life insurance policy designated a MEC is a bad thing if the intent of the life insurance policy is to set up a tax-free stream of income for retirement years.

For example, if you purchase whole life insurance or indexed universal life insurance as part of a zero percent taxation strategy, having your policy designated as a MEC life insurance completely destroys your strategy because of the modified endowment contract tax penalty.

If your intention for your cash value life insurance is to fund a “be your own banker” program, then certainly having a MEC designation removes the benefit of taking tax-free. Because of the modified endowment contract tax penalty, withdrawals from the insurance policy to fund purchases of goods, property, or services could become taxable.

 

How Can I Prevent my Policy from becoming Modified Endowment Contract life insurance policy?

In most cases, the last thing a policyholder will be familiar with is how TAMRA can affect their life insurance. These rules and conditions need to be monitored by your insurance carriers and an insurance professional and in almost every instance they are.

A Modified Endowment Contract is best described as a group failure if it is the result of unintended circumstances.

A problem could arise if you fail to pay attention to insurance company notices or are reluctant to take a call from your agent. In other words, the policyholder must take some responsibility for the terms and rules concerning their insurance contract, especially if it is a single-premium contract.

If your intention is to develop a stream of income that can be taken on a tax-free basis and to avoid unintended tax consequences that come with the MEC designation, make certain that your insurance professional is up to the task of keeping an eye on your insurance policy and has the experience needed to keep you out of harm’s way.

Contact Ogletree Financial at 1-800-712-8519 and let us answer your questions about modified endowment contract ins and outs.

Frequently asked Questions

What is a MEC?

modified endowment contract

The term modified endowment contract (MEC) designates that the funding of a life insurance contract has surpassed the limits set according to federal tax law. This means that the IRS no longer considers the contract to be a life insurance contract. This classification was implemented by the IRS to discourage the use of life insurance products to avoid paying taxes.

Is a MEC a good thing or does it cause problems?

no exam life insurance

For most owners of cash-value life insurance, they know in advance whether a MEC is a good thing. There are certain circumstances when a MEC provides an excellent solution for the defined needs of the policyholder. Here are three instances when a MEC is a good thing:
Used for estate planning
Used for college funding
When a MEC becomes an annuity

When is a MEC a problem for the policyholder?

man with questions icon

Certainly, having a life insurance policy designated a MEC is a bad thing if the intent of the life insurance policy is to set up a tax-free stream of income for retirement years. For example, if you purchase whole life insurance or indexed universal life insurance as part of zero percent taxation strategy, having your policy designated as a MEC completely destroys your strategy of having tax-free income when you need it.

What is a good modified endowment contract definition?

A life insurance policy becomes a MEC when the funding of the life insurance contract has exceeded the limits set according to federal tax law. If this happens, the life insurance policy is considered an investment product by the IRS and subject to the same constraints as traditional investments like an IRA or 401(k).

author avatar
Doug Mitchell, CLU Independant Advisor
Doug Mitchell, CLU holds a BA degree in Finance from Auburn University as well as having obtained a Chartered Life Underwriter (CLU) designation from The American College in Bryn Mahr, PA. Doug has spent almost 30 years in the life insurance industry and has also held licenses to sell securities, long-term care insurance and home and auto insurance. Doug is a Top of the Table Million Dollar Round Table member (MDRT).  MDRT is a global, independent association of the world's leading life insurance advisors.  For two years, Doug served as President of the Auburn Opelika Association of Financial Advisors and has been a member of the Million Dollar Round Table. He obtained Life Millionaire status at Horace Mann Insurance Company and was awarded the Life Agent of the Year Award. Later in his career with New York Life he was an Executive Council Member. Doug currently serves as President of Ogletree Financial, a managing general agency serving life insurance agents and clients in all parts of the United States. Today, Doug’s main focus is servicing 1000s of policyholders and growing the agency through the reach of  insurancequotes2day.com.