A permanent life insurance policy turns MEC life insurance ( modified endowment contract)when you overfund the cash value account.
An individual who owns a permanent life insurance policy such as whole life will likely be aware of its cash value account. This account is found by a portion of your insurance premium, and the investment grows tax-deferred. However sounds nice, this tax break is attached with an asterisk
When excess money towards its cash value is overfunded into the account, the policy could be declared a MEC, while the life insurance coverage remains the same. If you withdraw money very early, you will end up facing additional taxes and penalties. However, you could avoid the designation if you know how and when modified endowment contract rules apply.
What is a modified endowment contract?
A MEC is known to be life insurance that has exceeded its contribution limits set by IRS. However, the IRS declares a life insurance policy to be MEC when the following statement is true.
- The policy does not pass the ‘7-pay test’
- The policy was issued on or after June 21, 1998.
The ‘7-pay test’ explained
The 7-pay test Is the verification method used by the IRS to verify whether a cash value policy has been overfunded. Such policies do have an annual limit on the amount payable to the account. The limit is determined by the number of premiums it takes for the policy to pay completely in the first seven years. To be fully paid up proves the coverage is paid for in full and no more premiums are needed to keep the coverage active at that moment. Most time, policyholders sometimes do pay excessive than the minimum premium required because the excess money goes into the cash value account and would upgrade the investment.
Nevertheless, if an individual pays more than the annual limit in the first seven years, the policy will fail the 7-pay test and could be designated a MEC.
Let’s take for instance. If an individual policy’s annual premium limit is $1000 and he/she ends up paying double i.e $2000 in the second year of owning it, this will trigger a MEC conversion.
Nerdy tip: if you happen to convert your life insurance policy to become MEC, the designation cannot be reserved. But if you overpay, don’t be afraid. You will be notified by your insurer and will be given the chance to by your insurer to refund the excess money to avoid MEC designation.
The excess premium will be returned to you 2-months after the end of your life insurance policy’s contract year to avoid the policy from failing the 7-pay test.
The first seven years of a policy is being active when the 7-pay test is applied. When material change is made to your coverage, the clock gets reset for another seven years. The material change will alter the coverage, such as increasing the death benefit or adding a life insurance rider.
How does MEC insurance work?
The principle of a modified endowment contract is different from a life insurance policy. The death benefit is constant which implies that your payout will be offered to your life insurance beneficiaries when you die. And the cash value account still grows tax-deferred. But when the fund is withdrawn from the account, you will be offered more taxes fees than with a life insurance policy.
This happens when the IRS treats withdrawal from a MEC differently. When money from a life insurance policy is withdrawn, the “policy basis” is withdrawn first. This basis is the amount you contributed through your premiums, you end up withdrawing it tax-free.
MEC withdrawals incur a 10% tax penalty if you take out the money before turning 59½ years old. The 10% only applies to the gains, but because the gains are withdrawn first, you’ll likely pay the penalty