A Modified Endowment Contract (MEC) is a cash-value life insurance policy whose cumulative premiums have exceeded the amount allowed under U.S. federal tax law limits.
In the 1970s, life insurance companies utilized the tax-advantage status of cash-value life insurance contracts to create products that allowed the policyholder to accumulate cash holdings. The U.S. government viewed the policies as tax shelters and passed the Technical and Miscellaneous Revenue Act (TAMRA) to address it.
To be a MEC, the policy must meet the requirements of IRS Section 7702 and fail the 7-pay test outlined in TAMRA. In a MEC, withdrawals are typically taxed as ordinary income instead of being treated as non-taxable income.
History of Modified Endowment Contracts
In the 1970s, life insurance companies were seeking to leverage certain tax advantages of cash-value life insurance contracts. The life insurers designed products that allowed policyholders to accumulate cash (that could be withdrawn tax-free).
The contract was created on or after June 20, 1988.
It meets the statutory definition of a life insurance policy (IRS Section 7702).
It fails to meet the 7-pay test.
Understanding Modified Endowment Contracts
A MEC contract is a life insurance policy whose cumulative premiums have exceeded U.S. federal tax law limits. In other words, the IRS no longer considers the MEC a life insurance contract. Instead, it is classified as a specialized vehicle for the purpose of tax avoidance.
A life insurance policy is considered a MEC by the IRS if it meets the following criteria:
1. Made on or after June 22, 1988
Contracts entered before said date are not subject to the payment of premiums under federal law. However, if an individual has renewed an older life insurance policy after said date, it is considered a new policy and is subject to the 7-pay test outlined in TAMRA.
2. Meets the statutory definition of a life insurance policy
If a contract between the insurance company and the insured is created to pay out based on death, then it is considered a life insurance policy.
3. Fails to meet the 7-pay test
If the policy stipulates a premium that would guarantee a guaranteed paid-up policy within seven years from the inception of the policy, then it passes the 7-pay test. If it does not meet the criteria (it pays a guaranteed premium beyond seven years), then it fails the 7-pay test.
If a life insurance policy meets the criteria above, it is considered a MEC and is therefore taxed differently to not create a tax shelter.
Tax Implications of a Modified Endowment Contract
There are a few tax implications that an individual who holds a MEC must consider, including:
1. Withdrawals before 59.5 years of age
A 10% premature withdrawal penalty may be applied against the amount withdrawn.
2. No tax on death benefits
There is no applicable tax on death benefits provided by the policy, which is very similar to many other life insurance policies.
3. LIFO taxation applies to MECs
Unlike other life insurance policies, a MEC is subject to last-in-first-out taxation on all gains that are classified as regular income. However, the cost basis of the policy and withdrawals are not subject to taxation.
Several other tax implications are associated with a MEC, and they are outlined in the IRS’s documentation.
Taxation of MECs
A MEC, which is usually classified as just a life insurance policy before receiving MEC status, offers the policyholder several tax benefits, including:
Tax-free death benefit
Deferred taxation on all contract growth until the death of the policyholder, which means the entire value of the contract is usually passed to the next generation tax-free.
Withdrawals from the life insurance policy are tax-free up to the cost basis of the contract.
Once a life insurance policy is identified and classified as a MEC, it loses some of its tax benefits. The change in classification is irreversible, and the MEC is then taxed in the same manner as a non-qualified annuity. Non-qualified annuities are taxed using LIFO accounting.
In LIFO taxation, all withdrawals from the contract are considered fully taxable as ordinary income to the extent of growth in the contract. For example, if a MEC contract comes with a principal of $200,000 and pays a 10% interest, then the contract will grow by $20,000 in the year. If the policyholder decides to withdraw the gain, it is considered ordinary income and would be taxed first.
An individual takes out a life insurance policy with an annual 7-pay premium equal to $20,000. It means that the cumulative premiums paid for the contract cannot exceed $20,000, or it is in violation of the 7-pay test.
In year 5, the individual decides to reduce the value of the policy. It will lower the 7-pay premium. Assume that the premium is reduced to $10,000.
If the individual already paid more than $10,000 in premiums during year 1 through year 4, then it fails the 7-pay test outlined in TAMRA.
The life insurance policy is considered a MEC because:
The contract was formed after June 22, 1988.
It meets the definition of a life insurance policy.
It failed the 7-pay test.
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