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If you own a permanent life insurance policy such as whole life, you’ll likely be aware of its cash value account. A portion of your insurance premium funds this account, and the investment grows tax-deferred. Although it sounds great, this tax break comes with an asterisk.
If you overfund the account by contributing too much money toward its cash value, the policy could be declared a modified endowment contract, or MEC. While your life insurance coverage won’t change, you could face additional taxes and penalties for withdrawing money early. But you can avoid the designation if you understand how and when MEC rules apply.
What is a modified endowment contract?
A modified endowment contract is a life insurance policy that has exceeded contribution limits set by the IRS. The IRS will declare a life insurance policy to be an MEC if both of the following statements are true:
The policy was issued on or after June 21, 1988.
The policy does not pass the “7-pay test.”
The ‘7-pay test’ explained
The 7-pay test is what the IRS uses to verify whether a cash value life insurance policy has been overfunded. These policies typically have an annual limit on how much you can pay into the account. This limit is based on the amount of premiums it takes for the policy to be fully paid up in the first seven years. To be fully paid up means the coverage is paid for in full and no more premiums are required to keep the coverage active. Policyholders sometimes pay more than the minimum premium because the additional money goes into the cash value account and may boost the investment. However, if at any point within the first seven years you pay more than the annual limit, the policy will fail the 7-pay test and could be designated an MEC.
For example, if your policy’s annual premium limit is $1,000, and you pay $2,000 in the second year of owning it, it would trigger an MEC conversion.
The 7-pay test applies to the first seven years of a policy being active. However, if you make material changes to your coverage, the clock gets reset for another seven years. A material change is something that alters the coverage, such as increasing the death benefit or adding a life insurance rider.
How does MEC insurance work?
Modified endowment contracts are not too dissimilar to life insurance. The death benefit remains intact, which means your life insurance beneficiaries will still receive the payout when you die. And the cash value account still grows tax-deferred. However, when you withdraw funds from the account, you may be subject to more taxes and fees than with a life insurance policy.
This is because the withdrawals from an MEC are treated differently by the IRS. When you take money from a life insurance policy, the “policy basis” is withdrawn first. The basis is the amount you’ve contributed through your premiums, and you can withdraw it tax-free. So, if you don’t take out more than the basis, you won’t be taxed. Under a modified endowment contract, the gains are withdrawn first, which are taxed as ordinary income.
MEC withdrawals also typically incur a 10% tax penalty if you take out the money before turning 59½ years old. The 10% only applies to the gains, but because the gains are withdrawn first, you’ll likely pay the penalty.
Paid-up additions rider
You may come across the term “paid-up additions,” or PUA, when researching modified endowment contracts. A PUA rider essentially allows you to add small amounts of permanent life insurance funded by dividends. Policyholders can use PUAs to increase the policy's overall death benefit and cash value, while maintaining the correct ratio of insurance to investment, and avoid an MEC conversion.
Pros and cons of a modified endowment contract
If your policy is designated an MEC, it doesn’t necessarily equal disaster. The MEC rules were created to prevent policyholders from using life insurance policies as tax-free investment havens. If you don’t plan on withdrawing the money early, you could heavily fund the account and take advantage of the tax-deferred growth for retirement or estate planning purposes.
However, if you want to withdraw or borrow against the cash value before retirement, you’ll want to avoid MEC status.
Talk to a fee-only financial advisor before making any permanent investment decisions with your life insurance policy.
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Life insurance policy vs. modified endowment contract
Permanent life insurance
Modified endowment contract
Death benefit payout
Tax-deferred cash value growth
Gains subject to income tax
Order of withdrawals
Policy basis first.
Tax penalties for early withdrawals
Yes, 10% penalty on the withdrawal of gains before age 59½.