A modified endowment contract, usually called a MEC, is a type of life insurance contract that gets a different tax treatment under the U.S. tax code. The tax code defines a MEC as a cash-value life insurance policy that was written after June 21 of 1988 and fails the 7-pay test (26 U.S. Code 7702A).
The 7-pay test basically means that premiums paid in the first seven years of a life insurance contract should not exceed the net level premiums to fully fund the policy. The 7-pay test discourages the use of life insurance for tax avoidance by limiting certain favorable tax treatments of life insurance from policies that accumulate premiums too quickly.
The biggest distinction between the tax treatment of a typical life insurance contract and a MEC is that distributions removed from a MEC during the insured person's lifetime are first taxed as income to the extent of any gains in the contract. This includes either loans or withdrawals from the cash account.2 The MEC tax treatment was put in place to limit certain favorable tax treatments when the life insurance contract was not purchased primarily for the insurance.
The MEC tax treatment does not affect the death benefits that policy beneficiaries receive. In most cases, receiving the proceeds from the policy's death benefit is still a tax-free event. Accordingly, the MEC tax treatment should not always prevent people from considering a MEC for part of their portfolio.
To understand this, consider the fact that many insurance clients are still mainly looking at buying life insurance as a way to leave money to heirs. A MEC can still do that. Consumers may also be attracted to the idea of growing a cash account fast or enjoying other insurance policy benefits, and a MEC may also provide a good solution for these people.
These are some reasons to consider a policy that does not meet the 7-pay test:
- Some policies are structured to take advantage of the fact that a MEC can be over-funded quickly to maximize the death benefit.
- MECs can provide a death benefit to your heirs that is income tax-free, which can be an advantage over some other financial instruments.
- Many hybrid life insurance policies also include an additional benefit that makes them a type of long-term care insurance alternative, and such use could avoid the MEC tax treatment or make the concern minimal.
- MEC owners could still enjoy the tax-deferred growth as an insurance contract as long as they don't take withdrawals or policy loans.
People who want to find a financial product that will allow them to make quick disbursements or loans might find that a modified endowment contract is not the right solution for their needs.
However, people who mostly wish to purchase coverage on their lives and possibly, provide themselves with emergency protection while they are still alive, might wish to discuss some of the advantages of a MEC with an insurance professional. (You are encouraged to consult with your own legal or tax professional to confirm how the tax treatment of a MEC may apply to you.)
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Joe Stark is the CEO of Crown Atlantic Insurance, LLC in Boca Raton, Fla. Stark is an insurance industry veteran with more than 25 years of experience. For more of his reports, Go Here Now.
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