What Is a Modified Endowment Contract, or MEC?

In the event you personal a everlasting life insurance coverage coverage equivalent to entire life, you’ll probably pay attention to its money worth account. A portion of your insurance coverage premium funds this account, and the funding grows tax-deferred. Though it sounds nice, this tax break comes with an asterisk.

In the event you overfund the account by contributing an excessive amount of cash towards its money worth, the coverage might be declared a modified endowment contract, or MEC. Whereas your life insurance coverage protection gained’t change, you can face further taxes and penalties for withdrawing cash early. However you possibly can keep away from the designation for those who perceive how and when MEC guidelines apply.

A modified endowment contract is a life insurance coverage coverage that has exceeded contribution limits set by the IRS. The IRS will declare a life insurance coverage coverage to be an MEC if each of the next statements are true:

1. The coverage was issued on or after June 21, 1988.

2. The coverage doesn’t go the “7-pay check.”

The 7-pay check is what the IRS makes use of to confirm whether or not a money worth life insurance coverage coverage has been overfunded. These insurance policies sometimes have an annual restrict on how a lot you possibly can pay into the account. This restrict is predicated on the quantity of premiums it takes for the coverage to be absolutely paid up within the first seven years. To be absolutely paid up means the protection is paid for in full and no extra premiums are required to maintain the protection energetic. Policyholders generally pay greater than the minimal premium as a result of the extra cash goes into the money worth account and should enhance the funding. Nonetheless, if at any level throughout the first seven years you pay greater than the annual restrict, the coverage will fail the 7-pay check and might be designated an MEC.

For instance, in case your coverage’s annual premium restrict is $1,000, and also you pay $2,000 within the second yr of proudly owning it, it will set off an MEC conversion.

Nerdy tip: As soon as a life insurance coverage coverage turns into an MEC, the designation can’t be reversed. However for those who overpay, don’t panic. Your insurer will notify you and provide to refund the extra cash to keep away from an MEC designation. The surplus premiums should be returned to you inside 60 days after the tip of your coverage’s contract yr to forestall the coverage from failing the 7-pay check.

The 7-pay check applies to the primary seven years of a coverage being energetic. Nonetheless, for those who make materials modifications to your protection, the clock will get reset for one more seven years. A fabric change is one thing that alters the protection, equivalent to rising the loss of life profit or including a life insurance coverage rider.

Modified endowment contracts should not too dissimilar to life insurance coverage. The loss of life profit stays intact, which implies your life insurance coverage beneficiaries will nonetheless obtain the payout once you die. And the money worth account nonetheless grows tax-deferred. Nonetheless, once you withdraw funds from the account, you might be topic to extra taxes and charges than with a life insurance coverage coverage.

It’s because the withdrawals from an MEC are handled otherwise by the IRS. While you take cash from a life insurance coverage coverage, the “coverage foundation” is withdrawn first. The idea is the quantity you’ve contributed by means of your premiums, and you may withdraw it tax-free. So, for those who don’t take out greater than the premise, you gained’t be taxed. Beneath a modified endowment contract, the features are withdrawn first, that are taxed as extraordinary earnings.

MEC withdrawals additionally sometimes incur a ten% tax penalty for those who take out the cash earlier than turning 59½ years previous. The ten% solely applies to the features, however as a result of the features are withdrawn first, you’ll probably pay the penalty.

It’s possible you’ll come throughout the time period “paid-up additions,” or PUA, when researching modified endowment contracts. A PUA rider primarily permits you to add small quantities of everlasting life insurance coverage funded by dividends. Policyholders can use PUAs to extend the coverage’s total loss of life profit and money worth, whereas sustaining the proper ratio of insurance coverage to funding, and keep away from an MEC conversion.

In case your coverage is designated an MEC, it doesn’t essentially equal catastrophe. The MEC guidelines had been created to forestall policyholders from utilizing life insurance coverage insurance policies as tax-free funding havens. In the event you don’t plan on withdrawing the cash early, you can closely fund the account and reap the benefits of the tax-deferred progress for retirement or property planning functions.

Nonetheless, if you wish to withdraw or borrow towards the money worth earlier than retirement, you’ll need to keep away from MEC standing.