MEC. The dreaded acronym. When you’re the owner of a tax advantaged whole life insurance policy you’ve probably heard of this acronym. It stands for Modified Endowment Contract. When a life insurance policy becomes a MEC it can have severe tax implications. Properly funding a cash accumulating life insurance policy is pertinent. And knowing the MEC basics is important whether your policy is designed to be used for isnurance protection, retirement, investing, business, estate purposes or a mixture of the above.
TAMRA & DEFRA are the legal acts that define how life insurance policies can be funded and taxed but they are regulated under section 7702A of the IRC. If a policy does become a MEC then many of the tax benefits are lost. The distributions are treated as income to the extent of the gain and they may incur a 10% penalty.
“Section 7702A defines a modified endowment contract (MEC) as a contract that meets the requirement of § 7702 but fails to meet the 7-pay test of § 7702A(b), or that is received in exchange for a contract that is a MEC. Under § 7702A(b), a contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before that time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.” More on this excerpt can be found here.
So what is the 7-pay test and how do we prevent the life insurance policy from becomng a MEC? The 7-pay test requires that the accumulated values do not exceed the sum of the premiums paid over that 7 years…or what would have been paid in premiums over that 7 years had they been paid annually.
Different insurers have come up with different solutions. Some require premiums to be paid every year for the first 7 years. Others use term insurance to boost the death benefit and reduce the number of premiums. The bottom line is that you want to get as close to the MEC limit as possible without exceeding it. I’ve found this article to be extremely helpful in understanding the nuances of modified endowment contracts. I hope you do too.
Here’s to a MEC-free policy and all the tax benefits that come with it!
Scott Storace (775) 781-5464
