# Modified Endowment Contracts (MEC): Definition, Tax Implications, Benefits

## What Is a Modified Endowment Contract (MEC)?

A modified endowment contract (MEC) is a type of life insurance policy that has lost its tax benefits because it has excess cash value.

The Internal Revenue Service (IRS) classifies whether your life insurance is an MEC, using the "seven-pay test" for determination. If your cash value life insurance policy is classified as an MEC, you lose tax breaks for policy withdrawals and loans. This permanent change can happen when you pay excess premiums in too short a period.

In the 1980s, Congress passed a law to limit the practice of life insurers offering policies that featured substantial cash value accumulation to take advantage of the tax-free growth of many of their products.

Tax implications of MECs are losses of tax advantages for withdrawals and loans, last-in-first-out (LIFO) taxation, and penalties for early withdrawals.

Potential advantages of MECs include specific financial strategies, such as estate planning.

### Key Takeaways

*   Modified endowment contracts (MECs) are life insurance policies that lose tax benefits due to excess cash value.
*   An MEC's classification is determined by the IRS using the "seven-pay test."
*   Withdrawals from an MEC are taxed and may incur penalties if made before age 59½.
*   Despite tax drawbacks, MECs can offer better low-risk yields than savings accounts and assist in estate planning.
*   The tax-free death benefit of an MEC remains intact, making it useful for transferring wealth.

![Modified Endowment Contract (MEC)](https://www.investopedia.com/thmb/0Ur3AdQdJBu_E_l1hOtlGMSgeFI=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/modified-endowment-contract.asp-final-210edcf3a4c54a0db5ad4cb0d58563fa.png)

*When the IRS no longer recognizes a policy as a life insurance contract because the total collected premiums and cash value exceed federal tax law limits, it becomes a MAC. — Ryan Oakley / Investopedia*

## In-Depth Guide to Modified Endowment Contracts (MECs)

A modified endowment contract comes about when the IRS no longer recognizes a policy as a life insurance contract because the total collected premiums and cash value exceed federal tax law limits. The limit is set based on IRS rules about the maximum amount of premiums that can be paid into the policy in its first seven years. This rule prevents using "life insurance" to avoid taxes when it's really an investment.

In the 1970s, many life insurers took advantage of the tax-free growth of many of their products by offering policies that featured substantial cash value accumulation. Policyholders could withdraw interest and principal in the form of a tax-free loan, which made the policies de facto tax shelters. Congress passed a law in 1988 to limit this practice.

Some life insurance policyholders, often [high-net-worth individuals](https://www.investopedia.com/articles/financial-advisors/111215/why-wealthy-should-buy-lots-life-insurance.asp), choose to overfund a policy with a cash value component, then take periodic loans from it while living, effectively turning the policy into an investment. However, doing this reduces the policy's [death benefit](https://www.investopedia.com/terms/d/deathbenefit.asp) for heirs. If your children are grown and your retirement resources are adequate, this approach may appeal but be aware of the cash value limits that might push your policy into MEC status.

### Key Criteria for MEC Classification and the Seven-Pay Test

Specifically, a life insurance policy is considered an MEC by the IRS if it meets three criteria:

1.  The policy was entered 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](https://www.investopedia.com/articles/insurance/10/avoid-modified-endowment-contract-traps.asp)) "seven-pay test."

> **Important**
>
> The IRS requires a life insurance policy to comply with a strict set of criteria to avoid becoming an MEC.

The seven-pay test checks if premiums in the first seven years exceed the amount needed to fully pay the policy. Policies become MECs when the premiums paid to the policy are more than what was needed to be paid within that seven-year time frame.

Life insurance policies entered into before June 20, 1988, aren't subject to restrictions on the payment of premiums over the money allowed under federal laws. However, the renewal of an older life insurance policy after this date is considered a new policy and must be subjected to the seven-pay test.

### Strategic Use of Paid-Up Additional Riders to Prevent MEC Status

A life insurance policy can avoid triggering MEC status as long as the amount of cash held in the policy remains a certain amount below the death benefit amount (known as the corridor).

If you use a policy to accumulate cash value, one solution to avoid MEC status is to increase the death benefit through [paid-up additional insurance (PUA)](https://www.investopedia.com/terms/p/paidup-additional-insurance.asp), which raises the corridor's ceiling. PUA insurance is added whole life insurance coverage purchased with the policy’s dividends. It's like small packets of life insurance that are entirely paid for.

## Understanding the Tax Impact of Modified Endowment Contracts

The [cost basis](https://www.investopedia.com/articles/investing/060313/what-determines-your-cost-basis.asp) within the MEC and withdrawals from one aren't subject to taxation. In the case of insurance, the cost basis equals the total amount you paid into an asset such as a permanent life insurance policy. It is usually figured as the premiums you paid. Any cash value balance above what you paid in premiums counts as your interest gains.

Unlike traditional life insurance policies, taxes on gains are considered regular income for MEC withdrawals under [last-in-first-out (LIFO)](https://www.investopedia.com/terms/l/lifo.asp) accounting methodology. This taxation of payouts is worse for an MEC policyholder because it provides for taxable interest to be distributed first, rather than the tax-free principal, as with first-in-first-out (FIFO) methodology.

In addition, the taxation of withdrawals under an MEC is similar to that of non-qualified [annuity](https://www.investopedia.com/terms/a/annuity.asp) withdrawals. For withdrawals before the age of 59½, you may need to pay the IRS a premature withdrawal penalty of 10%.

Another serious drawback with an MEC is that it removes the tax benefits for policy loans. In a traditional life insurance policy, you can borrow your cash value, including your earnings above premiums paid, without owing income tax. In an MEC, taking out your gains through a loan counts as a taxable withdrawal. The 10% premature penalty also applies before the age of 59½. Once again, loans operate under LIFO, so gains come out first. After you've taken out your gains, you could borrow the remaining cash value representing your premiums paid without owing taxes.

As with traditional life insurance policies, MEC death benefits aren't subject to taxation. Modified endowment contracts are usually purchased by individuals who are interested in tax-sheltered, investment-rich policies, and who don't intend to make pre-death policy withdrawals.

The tax-free death benefit of MECs can be useful in [estate planning](https://www.investopedia.com/terms/e/estateplanning.asp) if the estate meets certain criteria. Policyholders who don't withdraw money can leave a large amount to [beneficiaries](https://www.investopedia.com/terms/b/beneficiary.asp).

## Evaluating the Advantages and Disadvantages of MECs

Pros

*   Offers higher yield on low-risk funds than some alternatives
    
*   Allows for smooth, tax-free asset transfer after the holder's death
    
*   Cash value can be borrowed against though taxes apply
    

Cons

*   Erases tax advantages for withdrawals and loans
    
*   Cash value in the policy becomes less accessible
    
*   Borrowing may reduce the death benefit for heirs
    

### Pros Explained

**Higher Yield on Low-Risk Funds**

Some individuals [may benefit from](https://www.investopedia.com/articles/insurance/10/avoid-modified-endowment-contract-traps.asp) purchasing an MEC, even if not for life insurance, because it often offers a higher yield on effectively riskless money; a better return than savings accounts or [certificates of deposit (CDs)](https://www.investopedia.com/terms/c/certificateofdeposit.asp).

**Tax-Free Asset Transfer After Death**

MECs allow for the tax-free shifting of assets to beneficiaries, without probate proceedings, upon the owner's death.  

**Can Be Borrowed Against**

MECs still provide a way to borrow against the cash value component while living. However, taxes apply to taking out the policy earnings even through a loan.

> **Warning**
>
> Once a policy becomes an MEC, it can't be changed back.

### Cons Explained

**Lost Tax Advantages**

With an MEC, withdrawals and loans are taxed and possibly penalized if early, just like withdrawals from non-qualified annuities. However, death benefits remain tax-free.

**Cash Value Is Less Accessible**

The funds inside an MEC will become far less accessible than in a life insurance policy, partly because of the potential tax assessed on withdrawals and loans.

**Borrowing May Reduce Death Benefit**

While borrowing against the cash value may continue with an MEC, doing this will lower the amount of the eventual benefit paid to heirs at the policy owner's death.

## How Are Taxes on Gains Figured in an MEC?

Taxes on gains are regular income for MEC withdrawals under last-in-first-out accounting methodology, meaning interest is disbursed before the principal. However, the cost basis, or the total amount of premiums paid, in the MEC withdrawals aren't subject to taxation for withdrawals.

## What Triggers an MEC?

An MEC is triggered if the amount of cash in a permanent life insurance policy exceeds the legal limits for it to be classified as insurance. The IRS uses a seven-pay test to determine MEC status. It looks at whether the premiums paid during the first seven years of the policy would exceed the amount for the policy to be paid up after seven years.

## How Can You Avoid MEC Status?

A life insurance policy can avoid triggering MEC status as long as the amount of cash held in the policy remains beneath the required corridor below the death benefit. If you use a policy to accumulate cash value, one solution is to increase the death benefit through paid-up additional insurance (PUA), which raises the corridor's ceiling.

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

Withdrawals are taxed similarly to those of a non-qualified annuity. For withdrawals before the age of 59½, a penalty of 10% may apply. As with traditional life insurance policies, MEC death benefits aren't subject to taxation.

## Is a Modified Endowment Contract a Good Thing?

Generally speaking, converting a life insurance policy to an MEC isn't good. This is because the MEC loses many of its prior tax advantages in place when it was classified as life insurance. However, purposefully creating an MEC can be an estate planning tool under certain circumstances.

## The Bottom Line

A modified endowment contract (MEC) is a life insurance policy that loses its tax advantages if it exceeds IRS-defined cash limits. Once classified as an MEC, tax treatment changes for withdrawals and loans, making them less favorable. The MEC status is also permanent and often a disadvantage for policyholders looking for tax benefits.

Despite their tax implications, MECs can still be useful for specific purposes, such as offering higher low-risk yields and facilitating the tax-free transfer of assets to beneficiaries upon the owner's death.

It's important to understand the implications of MECs when considering your life insurance policy options. MECs can offer better yields than savings accounts and simplify asset transfer at death, but they erase tax advantages for withdrawals and loans, have less accessible cash value in the policy, and borrowing may reduce the death benefit for heirs.

_Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a financial professional to determine a suitable retirement savings, tax, and investment strategy._

> **Article Sources**
>
> 1.  MassMutual. "[Mind Your Policy Premiums Before You Get Into MEC Territory](https://blog.massmutual.com/insurance/a-policy-that-becomes-a-modified-endowment-contract%E2%80%8B)."
>     
> 2.  U.S. Congress. "[H.R.4333—Technical and Miscellaneous Revenue Act of 1988](https://www.congress.gov/bill/100th-congress/house-bill/4333)."
>     
> 3.  Internal Revenue Service. "[Revenue Procedure 2001-42](https://www.irs.gov/pub/irs-drop/rp-01-42.pdf)."
>     
> 4.  Internal Revenue Service. "[Revenue Ruling 2005-6](https://www.irs.gov/pub/irs-drop/rr-05-6.pdf)."
>     
> 5.  Duplifund. "[Modified Endowment Contract—'MEC'](https://www.duplifund.com/life/modified-endowment-contract-mec.aspx)."
>     
> 6.  Northwestern Mutual. "[What Is Cost Basis and How Do You Calculate It?](https://www.northwesternmutual.com/life-and-money/what-is-cost-basis-and-how-do-you-calculate-it/)"
>     
> 7.  Indexed Universal Life. "[FIFO to LIFO](https://indexeduniversal.life/glossary-post/fifo-to-lifo/)."
>     
> 8.  Thrivent. "[What Is a Modified Endowment Contract, or MEC?](https://www.thrivent.com/insights/life-insurance/what-is-a-modified-endowment-contract-or-mec)"