HomeFinanceWhat Is a Modified Endowment Contract, or MEC?

What Is a Modified Endowment Contract, or MEC?

If you personal a everlasting life insurance coverage coverage resembling entire life, you’ll doubtless pay attention to its money worth account. A portion of your insurance coverage premium funds this account, and the funding grows tax-deferred. Although it sounds nice, this tax break comes with an asterisk.

If you overfund the account by contributing an excessive amount of cash towards its money worth, the coverage might be declared a modified endowment contract, or MEC. While your life insurance coverage protection received’t change, you might face extra taxes and penalties for withdrawing cash early. But you may keep away from the designation when you perceive how and when MEC guidelines apply.

What is a modified endowment contract?

A modified endowment contract is a life insurance coverage coverage that has exceeded contribution limits set by the IRS. The IRS will declare a life insurance coverage coverage to be an MEC if each of the next statements are true:

  1. The coverage was issued on or after June 21, 1988.

  2. The coverage doesn’t move the “7-pay test.”

The ‘7-pay test’ defined

The 7-pay take a look at is what the IRS makes use of to confirm whether or not a money worth life insurance coverage coverage has been overfunded. These insurance policies sometimes have an annual restrict on how a lot you may pay into the account. This restrict is predicated on the quantity of premiums it takes for the coverage to be totally paid up within the first seven years. To be totally paid up means the protection is paid for in full and no extra premiums are required to maintain the protection energetic. Policyholders generally pay greater than the minimal premium as a result of the extra cash goes into the money worth account and will increase the funding. However, if at any level throughout the first seven years you pay greater than the annual restrict, the coverage will fail the 7-pay take a look at and might be designated an MEC.

For instance, in case your coverage’s annual premium restrict is $1,000, and also you pay $2,000 within the second yr of proudly owning it, it might set off an MEC conversion.

Nerdy tip: Once a life insurance coverage coverage turns into an MEC, the designation can’t be reversed. But when you overpay, don’t panic. Your insurer will notify you and provide to refund the extra cash to keep away from an MEC designation. The extra premiums have to be returned to you inside 60 days after the tip of your coverage’s contract yr to stop the coverage from failing the 7-pay take a look at.

The 7-pay take a look at applies to the primary seven years of a coverage being energetic. However, when you make materials modifications to your protection, the clock will get reset for one more seven years. A cloth change is one thing that alters the protection, resembling growing the demise profit or including a life insurance coverage rider.

How does MEC insurance coverage work?

Modified endowment contracts aren’t too dissimilar to life insurance coverage. The demise profit stays intact, which suggests your life insurance coverage beneficiaries will nonetheless obtain the payout once you die. And the money worth account nonetheless grows tax-deferred. However, once you withdraw funds from the account, you might be topic to extra taxes and charges than with a life insurance coverage coverage.

This is as a result of the withdrawals from an MEC are handled in a different way by the IRS. When you are taking cash from a life insurance coverage coverage, the “policy basis” is withdrawn first. The foundation is the quantity you’ve contributed by your premiums, and you may withdraw it tax-free. So, when you don’t take out greater than the idea, you received’t be taxed. Under a modified endowment contract, the positive factors are withdrawn first, that are taxed as peculiar revenue.

MEC withdrawals additionally sometimes incur a 10% tax penalty when you take out the cash earlier than turning 59½ years outdated. The 10% solely applies to the positive factors, however as a result of the positive factors are withdrawn first, you’ll doubtless pay the penalty.

Paid-up additions rider

You might come throughout the time period “paid-up additions,” or PUA, when researching modified endowment contracts. A PUA rider basically permits you to add small quantities of everlasting life insurance coverage funded by dividends. Policyholders can use PUAs to extend the coverage’s total demise profit and money worth, whereas sustaining the right ratio of insurance coverage to funding, and keep away from an MEC conversion.

Pros and cons of a modified endowment contract

If your coverage is designated an MEC, it doesn’t essentially equal catastrophe. The MEC guidelines had been created to stop policyholders from utilizing life insurance coverage insurance policies as tax-free funding havens. If you don’t plan on withdrawing the cash early, you might closely fund the account and reap the benefits of the tax-deferred progress for retirement or property planning functions.

However, if you wish to withdraw or borrow towards the money worth earlier than retirement, you’ll wish to keep away from MEC standing.

Life insurance coverage coverage vs. modified endowment contract

Modified endowment contract

Tax-deferred money worth progress

Gains topic to revenue tax

Tax penalties for early withdrawals

Yes, 10% penalty on the withdrawal of positive factors earlier than age 59½.

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