How to Avoid The Modified Endowment Contract Trap?

Moneymagpie Team 22nd Aug 2023 No Comments

Reading Time: 4 minutes

Whole life insurance policies were all the rage in the United States (US). While most policyholders only aimed to leave a legacy for their loved ones, many were more keenly interested in their cash value that could turn into high-growth, tax-sheltered funds.

Since then, an increasing number of policyholders invested large sums in their whole life insurance policies and grew them without paying regular tax rates. Even more appalling, many insurance companies advertised their products as tax-sheltered investments.

Eventually, the Internal Revenue Service (IRS) and the US Congress caught on these capital-gain taxes. They implemented the Technical and Miscellaneous Revenue Act (TAMRA) 1988 to sidestep this practice, leading to the modified endowment contract (MEC).

What’s a Modified Endowment Contract (MEC)?
What’s TAMRA’s 1988 “7-Pay” Test?
Can All Types of Life Insurance Be Declared a MEC?
What Are The Pros and Cons of MECs?
How to Avoid MEC?

What’s a Modified Endowment Contract (MEC)?

When policyholders pay too much in their premiums too quickly, their life insurance policy will be declared a “modified endowment contract” (MEC). More specifically, it’s a designation given to a “ cash-value” life insurance policy that has exceeded legal tax limits.

For a cash-value life insurance policy to be declared as MEC, it must meet three criteria:

purchased on or after June 20, 1988
met the statutory definition or standard of a life insurance policy
failed TAMRA’s 1988 “seven-pay” test

What’s TAMRA’s 1988 “7-Pay” Test?

The 7-pay test calculates the annual premium a cash-value life insurance policy must need to be paid up (e.g., without further premiums due) after seven-level annual premiums. This specific limit is called the “7-pay limit” or “MEC limit” and established by the IRS. The policy will become a MEC if the total premiums paid into a cash-value life insurance policy within seven years exceeds the 7-pay limit. Once it’s reclassified, it can’t be reversed.

For example, a policyholder purchases a $50,000 universal life insurance policy with a 7-pay limit of $1,000 each year. If the policyholder puts in $2,000 in Year 4, the policy will be classified as MEC.

Note that this 7-pay test is generally applied only in the first seven years after buying flexible-premium policies. A new 7-pay period must only be run if there’s a material change to the policy, such as adding riders, changing face amount coverage, or reducing the death benefit.

Can All Types of Life Insurance Be Declared a MEC?

Not all types of life insurance are subject to the MEC rule. For example, term life insurance policies, the most basic type of life insurance, don’t offer cash accumulation benefits. It only comes with the basic death benefit protection.

Instead, what can be declared MECs are the following:

Whole life insurance
Universal life insurance
Permanent life insurance

These three life insurance policies generate cash value in addition to the death benefit. The accumulated cash can be withdrawn by the policyholders either through a loan or partial surrender on a tax-deferred basis.

What Are The Pros and Cons of MECs?

On a positive note, the death benefit remains tax-free even if a policy is reclassified as MEC. Even in non-MEC policies, this benefit is generally not included in beneficiaries’ gross income for federal income tax.

The cash value of a MEC-classified policy also continues to grow tax-deferred. It can be a sound solution if a policyholder has significant assets they want to put in a tax-deferred vehicle. These assets will then go to beneficiaries at death on a tax-advantaged basis.

In fact, due to its capability of leaving a tax-free inheritance to beneficiaries, MEC policy is marketed as an estate planning tool. It’s touted as a better alternative to an annuity, which immediately becomes taxable at the policyholder’s demise.

One main issue of MEC-classified policies is its tax implications when the cash value is withdrawn or borrowed. MECs are like nonqualified annuities. Both are funded with after-tax dollars.

In other words, when a policyholder withdraws or borrows against their policy’s cash value, they pay taxes on the earnings they receive. This is because the IRS treats this fund as ordinary income.

Another problem of MEC is it reduces the death benefit. Although borrowing against the cash value may continue despite being classified as MEC, doing so will decrease the amount of the eventual benefit paid to the beneficiaries at the policyholder’s death.

How to Avoid MEC?

As stated, the standard way to avoid triggering MEC status is by following the 7-pay limit. Beside it, follow the corridor rule. Generally, it states that the amount of funds held in the policy must be below the death benefit amount.

However, if a policyholder wishes to use his accumulated cash value, increasing the death benefit is recommended to prevent the policy from becoming a MEC. One way to do so is to invest in paid-up additional insurance (PUA), which helps raise the corridor’s ceiling.

PUA is an added whole life insurance coverage purchased using earned dividends or with a PUA rider. It mainly supercharges a policy’s value over time and provides additional cash to withdraw or borrow against.

Final Thoughts

A MEC life insurance policy is neither good nor bad. It’s a great part of good estate planning, but this may not suit everyone’s goals. For others, MEC could feel like a tax trap. The good news is that MEC can be avoided. Still and all, whatever your current financial situation and goals are, it’s essential to be educated or, better, seek professional advice.

Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.

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