What is a Modified Endowment Contract?
Modified endowment contract (MEC) is a common term used in the life insurance industry. Life insurance is a popular way to protect your loved ones from a potential future loss in income. If you have a life insurance policy and premiums exceed a certain Federal limit, the policy is converted into a modified endowment contract.
In other words, a modified endowment contract is a contract to provide a similar service to life insurance. It can’t be legally called life insurance, which can be important for tax purposes. But otherwise, the two are very similar. Continue on to learn what a modified endowment contract is, how they work, and what you should know if you or a loved one have a modified endowment in place.
What is a modified endowment contract
When a life insurance policy exceeds the Federal limit for premiums, it becomes a modified endowment contract. Just like a traditional life insurance policy, a modified endowment contract requires monthly premium payments and offers a death benefit if the covered individual passes away.
With a regular life insurance policy, the benefit is generally not taxable. However, once the policy premiums exceed the Federal limit where it becomes a modified endowment contract, the proceeds usually become taxable.
If you can put away funds to invest and compound for your heirs and won’t need to withdraw in your lifetime, modified endowment contracts can be a useful tax planning tool. You can allow funds to grow with a tax-deferral and then pass the cash value on to your heirs as part of an inheritance tax-free, in some cases.
While an MEC is sometimes complicated, there are good reasons to use them in some estate plans.
Under a modified endowment contract what are the likely tax consequences?
Each modified endowment contract may work a little differently, so it may be a good idea to consult with your trusted attorney or tax professional to find out specific tax costs for your situation. If you are under 59 ½ years old, an additional 10% penalty applies.
Distributions from a modified endowment contract are similar to a non-qualified annuity. Once life insurance is converted to a modified endowment contract, it can’t be turned back into a life insurance policy with the old tax benefits. Withdraws are made on a last-in-first-out (LIFO) accounting methodology. The first withdrawals are usually taxed at your regular income tax rate. Later withdraws may still have some tax benefits.
How to avoid modified endowment contract
If you want to keep the tax benefits of your life insurance policy, you need to pay attention to the “seven-pay test,” also sometimes called the “7 pay test.” This test limits the premiums that can be paid into a policy over a seven year period, hence the name.
The SEC explains that “A policy will fail the 7-pay test if at any time in the first seven policy years, the amount paid into the policy exceeds the sum of the level premiums that would have been paid at that point under a policy that provided for paid-up future benefits after the payment of seven level annual payments.”
This rule applies to life insurance policies starting in mid-1988. For more than three decades, all life insurance policies must pass the seven-pay test to keep life insurance status.
What is the tax penalty on a modified endowment contract
In addition to regular income taxes that may be due, withdrawals before age 59 ½ years old are subject to an additional 10% tax penalty. The tax penalty on a modified endowment contract is significant, so seriously consider if you are able to delay withdrawals until you reach the key age.
If you are in the 24% tax bracket, for example, your total taxes and penalties would be as much as 34% of your withdrawal. If the insured individual does not make withdrawals from the policy while alive, it may be included in the estate and passed on to heirs tax-free in some cases. Again, consult with your trusted tax professional to find out if this applies to you.
Whose responsibility is it to make sure my policy doesn’t become a modified endowment contract
In an ideal world, your insurance agent would inform you of any modified endowment contract limits well before you reach them. However, it is a good idea to keep track of the limits yourself just to be safe. If you are not sure about the rules on your policy, contact your policy provider or life insurance agent for more information.
Here is an example of how it works. Let’s say the IRS limit for the seven-pay test is $30,000 for your policy. You can pay up to an average of $4,285 per year or $357 per month over the seven year period and still maintain life insurance status.
Which distributions from a modified endowment contract would be taxable
Picture the dairy section at your local grocery store. New milk is added at the back of the shelf so the oldest is at the front. To keep things fresh, grocers use a first-in-first-out inventory management system, or FIFO. At a hardware store, on the other hand, an item at the back of the shelf is just as good as the front of the shelf. If the last item to go on the shelf goes first, this is akin to last-in-first-out (LIFO) accounting.
Distributions from a modified endowment contract use LIFO accounting. Any investment gains in the account will generally be charged your regular income tax rate before the non-taxable distributions go through. Don’t make any withdrawals from a modified endowment contract until you know the tax treatment. It’s better to be prepared for taxes than get a surprise letter from the IRS.
Good uses for a modified endowment contract
While it doesn’t provide the same tax benefits as life insurance, modified endowment contracts are very useful estate planning tools for some families. Modified endowment contracts can be an investment vehicle and provide a rate of return. Just like whole life or universal life insurance, a modified endowment contract can grow in value over time.
Investments in a modified endowment contract can grow in a tax-deferred account for the lifetime of the insured individual. This works similarly to an IRA. Once the insured passes away, the account can be passed on to heirs tax-free, assuming the estate is under the limit for estate taxes. Estate taxes start at $11.4 million per individual for 2019.
Understand how modified endowment contracts affect your finances
There are plenty of households that have a good reason to use modified endowment contracts in their estate plans. However, you don’t want to have your life insurance policy turn into a modified endowment contract unless it’s planned. An accidental payment over the premium limit can convert your policy and create a taxable event. But you can also use a modified endowment contract to lower your taxes.
The use cases for a modified endowment contract can be somewhat complex. That’s why it can be valuable and useful for you to work with an individual or company with in-depth experience with life insurance and MECs. They may also have other options to get more value from your life insurance policy, such as a life insurance settlement.
Now you know the answer to the key question: what is a modified endowment contract? It is a financial tool that may be very useful for your estate plan. But it’s important to understand the law so you don’t end up with one unplanned.