Modified endowment contracts and the 7-pay test

A modified endowment contract (MEC) is a life insurance policy that has been funded with more premium than the tax law allows during its first seven years. It still pays its death benefit income-tax free, but its cash value is taxed like an annuity: loans and withdrawals count as taxable income first, and anyone under age 59½ can owe an extra 10% penalty. The test is in 26 U.S.C. §7702A, and the taxation rules are in §72(e).

Why MECs exist

Congress created the MEC category in 1988 (the Technical and Miscellaneous Revenue Act). Before then, a buyer could pay a large single premium into a policy with a small death benefit, let cash value grow tax-deferred, and borrow it out tax-free, using life insurance as a tax shelter. A policy that meets the definition of life insurance in section 7702 keeps its tax advantages, but §7702A takes away the favorable treatment of loans and withdrawals if the policy is overfunded early.

The 7-pay test

A policy fails the seven-pay test if the total premiums paid at any time in its first seven contract years exceed the sum of the "net level premiums" that would have fully paid up the policy's future benefits in seven level annual payments (§7702A(b)). Put simply, the insurer computes a 7-pay premium limit for your face amount and age, and your cumulative payments cannot get ahead of seven times that limit at any point in the first seven years.

Key points:

• A running limit. In contract year 1 you may pay up to one 7-pay premium, by year 2 up to two, and so on. Paying a little ahead of schedule within that running total is fine; paying several years' worth up front is not.
• A reduction in benefits restarts the clock. Lowering the death benefit in the first seven years, or after a material change, requires the test to be redone with the lower limit. A material change also starts a new seven-year period.
• Distributions near a failure. A distribution made within two years before a failure is treated as made in anticipation of it and is taxed under the MEC rules (§7702A(d)).
• Exchanged policies. When you swap policies in a 1035 exchanges: swapping policies without tax, the new contract gets its own test. A MEC that is exchanged stays a MEC.
• Once a MEC, always a MEC, with narrow exceptions. A policy cannot be cured by paying less later.
• Correction window. If premiums exceed the limit, the excess can be returned (with interest) within 60 days after the end of the contract year, and the policy will not be a MEC (§7702A(e)(1)(B)). Insurers usually monitor this and warn you.

How a MEC is taxed

Under §72(e)(10), distributions, loans, pledges and assignments of a MEC are taxed on a "last in, first out" basis, meaning that gain comes out before your premiums (basis). A loan is treated as a distribution, and interest accrued on a loan can add to the taxable amount. The 10% additional tax on the taxable portion applies under §72(v) unless the owner is 59½ or older, disabled, or taking substantially equal periodic payments. Death benefits remain tax-free under §101(a). For how ordinary policies are taxed, see how cash value is taxed: withdrawals, loans and surrenders.

All MECs issued by the same insurer to the same owner in the same calendar year are treated as one contract for taxation, so you cannot split gain among several MECs.

A hypothetical example

The following is hypothetical, with figures that are not market prices.

Say a 50-year-old buys a whole life policy with a 7-pay limit of $10,000 a year, and decides to put in $60,000 in the first year. Cumulative payments of $60,000 exceed the first-year limit of $10,000, so the policy is a MEC from the start (unless the excess is returned in time). Seven years later the cash value is $85,000 against $60,000 of premiums. If the owner, now age 57, borrows $30,000:

• the entire $30,000 is treated as coming out of the $25,000 of gain first, so $25,000 is taxable income;
• the remaining $5,000 is basis, so it is not taxed;
• the owner may also owe a 10% additional tax on the $25,000 taxable amount, about $2,500, because the owner is under 59½.

Had the same policy been funded with $10,000 a year, it would not be a MEC, and the loan would generally be tax-free as long as the policy stays in force.

Is a MEC ever a good idea?

The case for. A MEC can be a reasonable place for a large lump sum when the goal is the death benefit, not the cash. The death benefit is tax-free, growth is tax-deferred, and an older buyer past 59½ pays only ordinary income on gains taken out. Some people use single-premium policies to leave an inheritance larger than the money they put in, or to fund long-term care riders. Some policies are intended to be MECs.

The case against. The main attraction of permanent insurance as a living benefit, tax-free access to cash, is gone. Loans become taxable, and the 10% penalty applies to people under 59½. Annuities offer similar tax deferral with different features; see how annuities are taxed. Insurance-based "tax-free retirement income" plans, in particular, are designed to stay under the 7-pay limit; see using life insurance for retirement income.

How to avoid an accidental MEC

1. Ask for the 7-pay premium when you buy any cash-value policy that you plan to overfund, and keep your annual premium under it.
2. Understand the policy's target. Universal life illustrations may show the "MEC limit" next to the target premium and the minimum premium.
3. Be careful with lump sums. Dumping a bonus, inheritance or 1035 exchange proceeds into a policy can exceed the limit.
4. Avoid benefit cuts. Lowering the face amount in the first seven years can make a previously compliant policy a MEC.
5. Ask the insurer to flag a MEC before it happens. Most carriers' administration systems notify the owner when a payment would cause a MEC and let you reverse it.

Because MEC status is permanent and the tax effects are significant, confirm your policy's status with the insurer or a tax professional before taking a loan or withdrawal. The policy loan calculator shows how loan growth affects a policy but not its tax status.

Key takeaways

• A MEC is a policy that fails the 7-pay test in its first seven years because it was funded too quickly (IRC §7702A).
• A MEC's death benefit is still income-tax free, and cash value still grows tax-deferred.
• Loans and withdrawals from a MEC are taxed gain-first, with a 10% penalty before age 59½.
• MEC status is generally permanent, and a 1035 exchange does not cure it.
• Stay under the 7-pay limit, and ask your insurer for it, if you want tax-free access to cash value.