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What is a modified endowment contract (MEC)?
If you have permanent life insurance, your policy has a cash value component that accumulates over time. This can be used for a variety of expenses, from paying your premiums to supplementing your retirement income.
However, if you exceed the contribution limits for your cash value, the IRS can convert your life insurance policy into a modified endowment contract (MEC). The IRS uses “the seven-pay” test to determine whether you have overfunded your cash value. If you overpay the contribution limit within the first seven years of having your policy, you fail this test and the IRS will convert your policy into an MEC.
An MEC will maintain the benefits of your life insurance policy, but will have different tax implications. In this article, we’ll explain the differences between an MEC and life insurance and how to avoid MEC status so you can feel confident with your financial decisions.
MEC vs. Life Insurance: What’s the difference?
An MEC is a cash value permanent life insurance policy that has lost its tax benefits because the policy holder paid too much, too quickly into their coverage. This means your policy may turn into an MEC if you over-contribute to your life insurance. Fortunately, if your permanent life insurance policy is converted into an MEC, you won’t lose your life insurance coverage or benefits. Instead, the primary differences between the two are the tax treatment and implications.
While permanent life insurance policies typically have a variety of tax advantages, the same perks don’t apply to MECs. If you withdraw from the MEC before the age of 59 and a half, you may also be subject to a 10% premature withdrawal penalty. Once it’s converted to an MEC, any withdrawals you make from your policy are then treated as non-qualified annuities, which are investment products funded with after-tax dollars.
MECs also remove the tax benefits for any loans you may take from your permanent life insurance policy. For example, if you borrow against the cash value of a permanent life insurance policy, you won’t owe income tax on the loan. However, with an MEC, any loans taken from the cash value will be taxable. The death benefits of both a life insurance policy and an MEC won’t be subject to taxation.
Can you change your life insurance policy to avoid MEC status?
Once a life insurance policy is converted to an MEC, it cannot be reversed. The best way to avoid MEC status is to pass the seven-pay test by not overcontributing in the first seven years of your policy. And, if you make a significant change to your policy, like adding a rider, your seven-year test will start over again.
The IRS performs the seven-pay test to compare the premiums you paid within your first seven years of coverage to the remaining amount you’ll need to pay the policy in full.
If you overpay on your premium within the first seven years of your policy, your insurer will typically reach out to you about your status, giving you the option to request a refund of the overfunded amount to avoid MEC status. Seeking expert advice from a life insurance broker can help you understand the terms of your contribution limits and how to avoid MEC status.
Learn More About Life Insurance and MECs with SelectQuote
Navigating cash value contributions for your life insurance policy can be confusing. Working with an expert can help ensure you’re contributing within your limits and avoiding MEC status. With over 35 years of experience, SelectQuote can help you with any questions you have about your life insurance policy and MECs.
We’ll help you shop highly rated life insurance companies, offering a personalized experience based on your unique needs. Our licensed life insurance agents will help you find the right policy to protect your assets and prioritize your financial future—all while saving you time and money.
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