What Is A Modified Endowment Contract? (MEC Insurance)
A modified endowment contract (MEC) is a type of cash value life insurance policy that has exceeded certain tax limits. When a cash value life insurance policy meets the definition of a MEC, it loses its tax-advantaged status. This means that withdrawals and loans from the policy may be subject to income tax and penalties.
The definition of a MEC is based on the seven-pay test. The seven-pay test compares the cumulative premiums paid on the policy to the cumulative death benefit. If the cumulative premiums paid exceed the cumulative death benefit, the policy is considered a MEC.
There are a few exceptions to the seven-pay test. For example, if the policyholder dies or becomes disabled, the policy will not be considered a MEC. Additionally, if the policyholder withdraws all of the cash value from the policy, the policy will no longer be considered a MEC.
There are several potential drawbacks to having a MEC. First, withdrawals and loans from the policy may be subject to income tax and penalties. Second, the policy may no longer be eligible for certain tax-advantaged features, such as tax-free death benefits. Third, the policy may be more difficult to sell or transfer.
Using a Paid-Up Additional (PUA) Rider to Avoid an MEC
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).5
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), 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.
If you have a MEC, you should talk to a financial advisor to discuss your options. There may be ways to mitigate the tax consequences of withdrawals and loans from the policy. Additionally, you may be able to convert the MEC into a non-MEC policy.
Here are some tips for avoiding MEC status:
- Be careful not to overfund your cash value life insurance policy.
- If you need to take a loan from your policy, be sure to repay it promptly.
- If you are considering withdrawing money from your policy, talk to a financial advisor first.
If you have any questions about MECs, you should talk to a financial advisor or tax professional.