Your life insurance policy, depending on the type, may have a trap hidden amid the premiums. And once sprung, it can mean the loss of some attractive benefits that come with certain life insurance plans.
Not the death benefit, which is first and foremost the primary reason for having life insurance — to make sure your loved ones are protected and have the financial means to carry on after you are gone. It's rather the tax benefit on cash accumulation that certain types of life insurance policies offer beyond the basic death benefit.
What exactly is a modified endowment contract?
Simply put, paying too much in policy premiums too quickly will trigger a federal rule regarding life insurance. Your life insurance policy will be declared a “modified endowment contract” (MEC) and the tax benefits that accompany cash-value life insurance policies may be crimped.
For some people that isn’t a problem; that’s just the type of financial vehicle they want for estate planning purposes and they have no interest in withdrawing the policy’s cash value. But for others looking to use their life insurance to accumulate additional funds for retirement or emergencies down the road, it could be an issue. And while the number of policies that fall into the MEC category is relatively small, it’s still something to be aware of.
What life insurance can be declared a MEC?
Not all life insurance faces this kind of modified endowment contract treatment. Term life insurance, the most basic form of life insurance, doesn’t offer cash accumulation benefits, for example. It simply offers the basic death benefit protection.
But life insurance policies that do offer cash accumulation in addition to the death benefit, such as whole life insurance, universal life insurance, and other types of permanent life insurance, may be subject to the MEC rule.
That’s because these types of life insurance policies grow cash value over time on a tax-deferred basis. And policyowners are able to tap the cash value, either through a loan or partial surrender, on a tax advantaged-basis to help supplement retirement income, help a family member pay for college, or provide cash for an emergency.1
If, however, the life insurance policy involved has been declared a MEC, there could be tax consequences for accessing the cash value and perhaps even a penalty. (Related: 3 tax advantages of life insurance)
Whether or not these permanent life insurance policies do trigger the MEC rule depends on the size of the death benefit in the policy and the timing and amount of premium payments.
History: Why a MEC rule?
The MEC rule came into being in 1988 after Congress became concerned about some people using life insurance not so much for the death benefit protection for their family, but as a way to sidestep capital-gain taxes. Maximum long-term capital gains taxes during the 1970s through the mid-1980s ranged from 20 percent to as high as 39 percent.2
Before 1988, someone could buy a life insurance policy that allowed for large up-front payments or even a single premium, essentially parking a large amount of cash in a financial vehicle that allowed it to grow on a tax-deferred basis. And if that person needed the cash, he or she could take loans from the insurance policy on a tax-free basis. And those loans could last a lifetime, essentially being paid back out of the eventual death benefit.
The Technical and Miscellaneous Revenue Act of 1988 ended that practice by creating a test that differentiated between life insurance policies bought “primarily for investment purposes” versus life insurance policies bought for death protection and long-term value. 3
Life insurance or MEC? The ‘7-pay’ test
To avoid being declared a modified endowment contract, a life insurance policy must meet the “7-pay” test. This test calculates the annual premium a life insurance policy would need to be paid up after seven level annual premiums. (When a life insurance policy is “paid up,” no further premiums are due.) This is called the 7-pay limit or MEC limit, and is based on rules established by the Internal Revenue Code, setting the maximum amount of premium that can be paid into the contract during the first seven years from the date of issue in order to avoid MEC status.
Take, for example, a hypothetical situation where a policyowner buys a $50,000 universal life insurance policy that allows for flexible premium payments. Let’s assume the MEC limit for that policy is $1,000 each year for the first seven years of the contract. As long as the policyowner is only paying $1,000 per year, the life insurance policy won’t be reclassified. But if the policyowner puts in $2,000 in Year 4, then the cumulative premium payments would be $5,000 as opposed to the $4,000 in Year 4 that would be allowed under the 7-pay test. The life insurance policy then becomes a modified endowment contract.
Once a policy is declared a modified endowment contract, it can’t be reversed. And if a life insurance policy undergoes a material change (changing the coverage face amount of the policy or adding riders, for example) a new 7-pay period starts and the test is re-applied.
Modified endowment contracts still provide an income tax-free death benefit for the beneficiaries. And a MEC still provides tax-deferred cash value accumulation.
But any distributions from the cash value of the policy (or, now, endowment) can be subject to taxation to the extent that the money in the policy has grown. Also, any distributions are subject to an additional 10 percent penalty if the policyowner is younger than 59½ years old, promoting distributions that are more likely retirement oriented.
These tax consequences for life insurance policies that become modified endowment contracts cut down on the appeal of life insurance policies, particularly single premium policies, as a way of sidestepping taxes, seen so widely in the 1970s and 1980s. (Related: 3 uses for single-payment life insurance)
Instead, the changes promoted the core purposes of permanent life insurance as a way to protect one’s family and accumulate additional funds for retirement on a tax-advantaged basis.
When modified endowment contracts work
However, modified endowment contracts are appealing for some people with particular estate planning goals. After all, MECs still offer a tax-free death benefit and tax-deferred cash accumulation. So, they can be useful to individuals with the immediate wherewithal to support themselves throughout retirement and who want to pass on wealth. (Related: Estate planning for high-net worth households)
Indeed, some financial professionals believe MECs can offer better alternatives than some other financial vehicles.
“MECs can be used for estate planning, but mostly people want to stay away from them,” said Michael Fliegelman, founder and president of Strategic Wealth Advisors Network in New York. “They are misunderstood by most as they are actually tax favored — in comparing a MEC to a non-qualified deferred annuity as they are actually taxed better at death and grow without tax during life, if no withdrawals or loans are taken.”
For most people, however, avoiding the MEC classification is the better way to go. And most life insurance policies will have premium payment plans that steer clear of modified endowment contract qualification. In cases where a policyowner has unwittingly strayed into MEC territory, the insurance company (MassMutual particularly) will notify the policyowner and offer a refund to prevent the MEC designation. But there are strict time frames for taking action.
Of course, individual situations and circumstances can vary and sometimes determining what products and services make the best fit can get complicated. In those cases, it may be wise to contact a financial professional and talk through options.
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This article was originally published in December 2016. It has been updated.
1 Access to cash values through borrowing or partial surrenders will reduce the policy's cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.
2 Tax Foundation, “Federal Capital Gains Tax Collections, 1954-2009,” Sept. 14, 2010.
3 U.S. House of Representatives, “Conference Report: Technical and Miscellaneous Revenue Act of 1988,” Oct. 21, 1988.