What is a modified endowment contract (MEC)?

Modified endowment contracts (MECs) are a new class of insurance contracts introduced in order to counter widespread practices of using universal life, single-premium and limited-pay policies as tax-sheltered cash value accumulation and money-saving tools. To do that, Congress passed legislation modifying the tax law definition of a life insurance contract under Internal Revenue Code (IRC) section 7702.

A MEC differs from other life insurance contracts in its federal income tax treatment of living benefits. In contrast to other life insurance contracts, amounts received during the insured's lifetime under a modified endowment contract, are subject to federal income tax and might entail a 10% penalty tax. Still, cash accumulations and death proceeds are treated just as under any life insurance contract.

Basic Modified Endowment Contract Rules

• Policy contracts signed before June 21, 1988, are not subject to the MEC rules. Only if they undergo a material change, such as an increase in the death benefit, conversion or exchange from one policy to another, do they need to be tested under the MEC classification rules.
• All policies that undergo a material change and all policy contracts entered into after June 20, 1988, are subject to testing for a MEC status.
• A MEC status cannot be changed: once classified as a modified endowment contract, a life insurance policy remains a modified endowment contract regardless of any changes in the policy.
• Even if a policy would otherwise not be classified as a MEC , it automatically receives a MEC status if received in exchange for a modified endowment contract.
• The so-called "seven pay" test is applied to establish the MEC status of a life insurance policy in the following situations:
  • When a policy is issued after June 20, 1988;
  • To re-test any policy, regardless of the date it was entered into, in case there has been any material change in benefits;
  • To re-test policies issued after 20 June 1988 if the face value has been lowered within the first seven years.

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