Modified Endowment Contracts Explained

Last updated on February 16, 2022 by Mark Cussen in Life Settlements, Retirement Planning

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Investors who are looking for a way to leverage the assets that they leave to their heirs may find these contracts to be very useful.

If you have assets that you don’t plan to use during your lifetime but instead have earmarked for your future heirs, then you may want to take a look at converting some or all of those assets into a modified endowment contract (MEC).

What is a Modified Endowment Contract?

This unique vehicle enables you to leave a larger tax-free amount to your heirs with no additional out-of-pocket costs. But you need to understand the rules that govern the taxation and distribution of these vehicles to use them correctly and avoid an unnecessary tax bill.

Most cash value life insurance policies offer tax-free access to their cash value component either through direct withdrawals or policy loans. However, for a life insurance policy to be eligible for this tax treatment, it is required to pass what is known as the 7 pay test.

7 Pay Test

The 7 Pay Test places a limit on the number of premiums that can be paid into the policy over a period of seven years. If the premiums during this period exceed this limit, then the policy automatically becomes a modified endowment contract.

This test is designed to ensure that for a life insurance policy to remain valid, the difference in dollars between the cash value in the policy and the death benefit must be at least a certain amount at all times.

History of Modified Endowment Contracts

In the late 1970s, many life insurance companies sought to leverage the tax-advantaged status of cash value life insurance contracts by creating products that facilitated substantial accumulation of cash value, which would then allow the policy owner to make sizeable tax-free withdrawals at any time.

But Congress viewed these vehicles as tax shelters and decided to place a limit on the amount of money that could be placed into a flexible premium cash value policy. Thus the “7 pay test” rule was born as one of the components of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).

This act, therefore, created the MEC. Before TAMRA was passed, all withdrawals from a cash value life insurance policy were taxed on a first-in-first-out (FIFO) basis, which meant that all withdrawals were considered to be a tax-free return of principal up to the amount of premiums that had been paid.

But the seven-pay test instituted by TAMRA set a limit on the amount of premiums that could be paid into a flexible premium cash value policy and still retain FIFO tax status on withdrawals.

Furthermore, the IRS also has its own set of tax laws that apply on a per-policy basis that outline the maximum amount of premium that can be paid into the policy for both single and flexible premium non-mec policies.

These limits are based on the amount of level premium that it would take to pay up the policy after seven years and supercede those of the 7-pay test codified in TAMRA. Any violation of the IRS limits results in the policy immediately being reclassified to MEC status under federal tax law. This is true for whole life insurance, variable life insurance and universal life insurance policies.

Any single premium cash value policy is now classified as an MEC policy, and most life insurance companies will not allow their policyholders to pay premiums that will violate the seven-pay test. All flexible premium cash value policies have both an annual and a cumulative dollar limit for each policy that is determined by the amount of death benefit and the age of the insured.

For example, the IRS might stipulate that the maximum amount of annual premium that can be paid into a newly-issued policy is $6,784, and the maximum amount of premium that can be paid into the policy over 7 years is $30,000. But any remaining difference between the annual limit and the actual amount of premium that is paid is then automatically applied towards the following year.

modified endowment contracts

So if the policy owner paid $5,000 in premium into the policy this year, then the remaining $1,784 would be added to next year’s limit of $6,784 and thus raise that year’s limit to $8,568. But if the total premiums paid reach $30,000 within the seven year period, then only the minimum premium payment set by IRS guidelines can be paid until the end of the period.

Therefore the policy holder could not pay $6,784 of premiums every year for seven years, because this would obviously exceed the $30,000 limit. He could pay that amount every year until this limit is reached, and then pay the IRS guideline minimum required premiums for the remainder of the seven year period.

However, this limitation expires at the end of the seven year period, provided that no material changes have been made to the policy, such as an increase in the face amount or any additional riders or changes in the insureds on the policy. If any material change is made, then the seven-year test will be restarted.

A decrease in the death benefit is the one exception to this rule; a decrease will not automatically restart the seven year period, but it may result in the policy becoming reclassified as an MEC. This is because the seven-pay test will be reapplied to all cumulative premiums paid over the last seven years at the new lower limit, so it is possible that the policy can become an MEC due to premiums that were paid several years ago based on a higher death benefit.

In addition to reduction of the death benefit, other examples of reductions in benefits include cancellation of insurance policy, reduction in protection afforded by one or more riders attached to the policy or a lapse in the policy that is not reinstated within 90 days.

Modified Endowment Contract Taxes

Once a flexible premium cash value life insurance policy becomes classified as an MEC, it immediately loses its former tax benefits, and this transformation is irreversible. A MEC cannot become a life insurance policy ever again, regardless of circumstances.

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MEC’s are now taxed in the same manner as non-qualified annuities, which is on a last-in-first-out basis (LIFO), which means that all withdrawals are considered to be fully taxable as ordinary income to the extent of the growth in the contract.

For example, say a policy owner with an MEC with $100,000 of principal that pays an interest rate of 10% and $10,000 of growth (for a total value of $110,000) withdraws $10,000 from the contract.

The entire $10,000 would be classified as ordinary income, because the growth in the contract is taxed first. MEC’s also resemble IRAs, qualified plans and annuities in that any withdrawal that is taken before the contract owner is age 59 ½ will automatically be assessed a 10% early withdrawal penalty.

However, the interest or growth that is earned inside the contract grows on a tax-deferred basis.

Proper Use of Modified Endowment Contracts

You may be wondering at this point why anyone would want to purchase an MEC, given its income tax limitations and other drawbacks. MEC’s are most often used as an estate planning tool. Investment representatives who work in banks often use these products to leverage a client’s legacy that they leave to their heirs.

A common approach that they take is to divide the client’s money into three categories: now, later, and never.

  • “Now” – Money is invested in stable, short-term offerings such as CDs and money markets where it can easily be accessed.
  • “Later” – Money is typically invested in vehicles such as annuities or mutual funds that are geared to provide growth and income.
  • “Never” –  Money is usually liquid assets held by the client that they don’t intend to use during their lifetime. This last pot of money is where MECs can come in handy. A client with $100,000 in a CD that he intends to leave to his children could roll the balance over into a MEC when the CD matures. He will probably get a higher rate of interest in the MEC than he got in the CD, and interest and growth will accumulate on a tax-deferred basis like in an IRA or annuity. When he dies, the MEC will then pay out a tax-free death benefit equal to perhaps $250,000-two-and-a-half times the amount of his investment.

MEC’s are therefore useful estate planning tools for wealthy clients with large estates and money that they want to pass on to their heirs.

They usually have a declining back-end surrender charge schedule for withdrawals, so be sure to find out how much you can withdraw and when before you buy one of these contracts. Loans are also available in some contracts.

Be sure to find out what the death benefit will be (your advisor will give you this up front) and whether your heirs will pay any type of tax upon receipt.

Some contracts have a minimum guaranteed rate of interest, while others contain a selection of investment options to choose from.

But if you have liquid assets lying around collecting a paltry rate of interest that you intend to pass on to your children or other heirs, then a MEC could be an ideal estate planning tool for you.

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