Modified Endowment Contract (MEC)

What Is a Modified Endowment Contract?

A modified endowment contract (MEC) is a tax qualification of a life insurance policy whose funding surpasses federal tax law limits. The taxation structure and IRS policy classification permanently change after a life insurance policy transforms into a modified endowment contract.

Permanent life insurance contracts are conceded liberal tax advantages in the U.S., yet in the event that you put too much cash inside of a policy, it loses its status as "insurance." and turns into an investment vehicle all things considered. All in all, it no longer is treated as a life insurance policy, yet as a MEC. The MEC limits for a policy will rely upon its terms and death benefit amount. Your insurance company will caution you on the off chance that a policy is going to become, or has turned into a MEC.

Understanding Modified Endowment Contracts

A modified endowment contract (MEC) happens when the IRS no longer perceives a policy as a life insurance contract, in light of the fact that the total collected premiums surpass federal tax law limits. This classification tries to combat calling something "life insurance" to stay away from taxes.

In particular, a life insurance policy is viewed as a MEC by the IRS on the off chance that it meets three criteria:

1. The policy is placed into on or after June 20, 1988.
2. It must meet the statutory definition of a life insurance policy.
3. The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.

The seven-pay test determines whether the total amount of premiums paid into a life insurance policy, inside the first seven years, is more than whatever was required to have the policy thought about paid up in seven years. Policies become MECs when the premiums paid to the policy are more than whatever was required to have been paid inside that seven-year time span.

Life insurance policies went into before June 20, 1988, are not subject to the payment of premiums over the money permitted under federal laws. Nonetheless, the renewal of a more established life insurance policy after this date is viewed as new and must be subjected to the seven-pay test.

The IRS requires a life insurance policy to consent to a severe set of criteria to try not to turn into a MEC.

Tax Implications of a MEC

The taxation of withdrawals under the MEC is like that of non-qualified annuity withdrawals. For withdrawals before the age of 59 1/2, a premature withdrawal penalty of 10% may apply. Similarly as with traditional life insurance policies, MEC death benefits are not subject to taxation. Modified endowment contracts are typically purchased by people who are keen on tax-sheltered, investment-rich policies, and don't mean to make pre-death policy withdrawals.

Dissimilar to traditional life insurance policies, taxes on gains are ordinary income for MEC withdrawals under last-in-first-out (LIFO) accounting methodology. Be that as it may, the cost basis inside the MEC and withdrawals isn't subject to taxation. The tax-free death benefit makes MECs helpful for estate planning purposes, gave the estate can meet the qualifying criteria. Besides, policy owners who don't take withdrawals can give a huge sum of money to their beneficiaries.

Upsides and downsides of MECs

By and large, a MEC is unwanted for the owner of a life insurance policy. A MEC will see a large number of the tax advantages of life insurance vanish, and the money inside the MEC will become definitely less open than in a life insurance policy.

All things considered, a few people might benefit from purchasing a MEC (not really for life insurance) since it frequently offers a higher yield on successfully riskless money (i.e., more than savings accounts or CDs), and takes into consideration the transfer of assets to beneficiaries tax-free and without probate upon the owner's death.

That's what another downside is assuming that a MEC even is set off, it can't be scattered.

Features

• When a policy has set off MEC status, it can't be switched.
• The policy must fail to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) seven-pay test.
• These limits on the amount of cash inside a contract are in place to try not to manhandle tax advantages inherent in permanent life insurance.
• The taxation of withdrawals under the MEC is like that of non-qualified annuity withdrawals.
• A modified endowment contract (MEC) is the term given to a life insurance policy whose funding has surpassed federal tax law limits.

FAQ

What Are the Likely Tax Consequences of an Early Withdrawal Under a MEC?

Withdrawals are taxed much the same way to those of a non-qualified annuity. For withdrawals before the age of 59\u00bd, a penalty of 10% may apply. Similarly as with traditional life insurance policies, MEC death benefits aren't subject to taxation.

How Might You Avoid MEC Status?

A life insurance policy can try not to set off MEC status inasmuch as the amount of cash inside the policy stays underneath the required corridor below the death benefit. In the event that you utilize a policy to collect cash value, one solution is to increase the death benefit through [paid-up additions](/paidup-extra insurance) (PUA), which raises the corridor's ceiling.

How Are Taxes on Gains Figured in a MEC?

Taxes on gains are ordinary income for MEC withdrawals under rearward in-first-out accounting methodology. Nonetheless, the cost basis inside the MEC and withdrawals isn't subject to taxation.

Is a Modified Endowment Contract a Good Thing?

Generally talking, changing a life insurance policy over completely to a MEC is definitely not something worth being thankful for. This is on the grounds that the MEC loses a large number of its prior tax advantages that were in place when it was classified as life insurance. All things considered, intentionally making a MEC can be an estate planning tool in specific situations.

What Triggers a MEC?

A MEC is set off on the off chance that the amount of cash inside a permanent life insurance contract surpasses legal limits to be classified as insurance. This limit is set a certain amount below the amount of the policy's death benefit (known as the corridor). The IRS utilizes a heuristic test to determine MEC status. The seven-pay test checks out if the premiums paid during the first seven years of the policy would surpass the amount for the policy to be paid up following seven years.