Modified Endowment Contract (MEC) - Understand How it Benefits You (2022)

A Modified Endowment Contract, also known as a MEC, could be a great way to pass on assets to your heirs. Or, it could be the worst thing to happen to your whole life insurance policy. In this article, we’ll break down the pros and cons of a Modified Endowment Contract, explain how to use one for estate planning, and show you how to avoid having your whole life insurance policy from becoming a MEC.

What is a Modified Endowment Contract (MEC)?

To understand what a MEC is, you first have to understand the benefits of whole life insurance. In addition to a death benefit for your heirs, whole life insurance offers a number of living benefits to the policyholder:

  • A guaranteed rate of return
  • Liquidity
  • Protection against market volatility
  • Cash flow in retirement
  • Tax advantages

Whole life insurance policies come with a built-in savings component called cash surrender value. You can withdraw your cash value or use it in the form of a policy loan. Both offer liquidity and a way to increase cash flow.

The cash value of your policy not only grows when you pay a policy premium, it also earns a guaranteed rate of return—regardless of what happens in the stock market. When you purchase a policy through a mutual insurance company, you may also earn potential dividends.The accumulated interest and dividends in whole life insurance policies are eligible for certain tax advantages that make them attractive to people trying to grow and protect their wealth.

With all this in mind, it’s easy to see why people would want to put as much money as possible into a whole life insurance policy. And, for over a hundred years, many individuals and businesses have. In fact, banks and corporations today hold billions of dollars in whole life insurance.

The Technical and Miscellaneous Revenue Act (TAMRA)

Before Modified Endowment Contract laws were created, anyone who owned a policy could pay a single large premium or very large premiums over a short amount of time to quickly generate tax-deferred cash value. From there, owners could access the liquidity from their policy through policy loans without paying taxes.

By the 1970s, many insurance companies were creating products specifically designed to optimize cash value and advertising the tax benefits of owning them. Congress perceived this tax-benefit to be misused so legislation was specifically aimed at limiting the use of whole life insurance as a tax-sheltered investment.

Video: Modified Endowment Contract (MEC) - Explained

In 1988 the Technical and Miscellaneous Revenue Act, also known as TAMRA, was passed. TAMRA put limits on the amount of money that could be paid into an insurance policy, thereby regulating whole life insurance’s tax-advantaged status.

Under TAMRA, policies that were over-funded no longer qualified as life insurance policies, instead they fell under a new classification known as Modified Endowment Contracts, or MECs. MECs don’t have as many tax advantages. They function more similarly to investment tools like non-qualified annuities, and you may be penalized for accessing funds in a MEC before age 59 1/2.

Here is how the tax treatment of whole life insurance compare to those of a Modified Endowment Contract:

Taxes & Whole Life Insurance

  • Tax-free growth of interest and dividends
  • Growth of cash value can be used tax-free
  • Tax-free policy loans
  • Tax-free retirement income
  • Income tax-free death benefit
  • Estate tax-free death benefit

Taxes & Modified Endowment Contracts

  • Tax-deferred growth of interest and dividends
  • Growth of cash value is taxed when used
  • Policy loans are taxed
  • Retirement income is taxed
  • Income tax-free death benefit
  • Estate tax-free death benefit


When an insurance policy becomes a Modified Endowment Contract, the way they are accounted for shifts. This is why they are taxed differently.

Whole life insurance policies follow first-in-first-out accounting practices, or FIFO. When you take a withdrawal or a policy loan from your cash value, you are accessing the first funds you put into the policy (your premiums) first, up to the cost basis (the total amount of premiums paid). Once those funds have been depleted, you may be taxed on the remaining interest and dividends if you are taking a withdrawal (policy loans and death benefits remain tax-free).

Modified Endowment Contracts follow last-in-first-out accounting practices, or LIFO. When you take a withdrawal or a policy loan from your cash value, you are accessing the most recent funds put into the policy (interest and dividends) first. They are taxed, regardless of whether you are taking a withdrawal or a policy loan (the death benefit remains tax-free).

Video: Modified Endowment Contract (MEC) Investment Explained? | Tekeno Financial

When you have a Modified Endowment Contract and you withdraw funds or take out a policy loan, your subsequent taxes are due annually when you file your tax return. You’ll also have to pay an additional 10% penalty if you’re under age 59 1/2.

How Does a Policy Become a MEC?

Policyholders familiar with Modified Endowment Contracts will often ask what the set amount or number is to prevent their policy from entering MEC status. The answer is that there is no set amount, it is unique and individual to the policyholder and their death benefit threshold, which is outlined by the variables of age, gender, and overall health.

The 7-Pay Test

Whole life insurance policies are subject to what is called a “7-pay test” to determine whether or not they meet the qualifications of an insurance policy vs. a Modified Endowment Contract. The “7-pay test” places a limit on the number of policy premiums that can be paid into a policy over a 7-year period.

If policy premiums over the initial 7-year period don’t exceed the limit outlined by the variables of age, gender, and overall health, the whole life insurance policy will remain such for the rest of the policyholder’s life, provided they don’t make changes to the policy which would restart the 7-year period for which the policy must meet non-MEC requirements.

If, during the initial 7-year period or any subsequent 7-year periods imposed due to significant policy changes, a whole life insurance policy is overpaid it will fail the “7-pay test” and become classified as a Modified Endowment Contract. Certain tax advantages will no longer apply and the policy will function more like a non-qualified annuity than a cash value insurance product. The death benefit remains intact, but policy loans will no longer be tax-free.

At Paradigm Life, we structure whole life insurance policies so that they will pass the “7-pay test” and function as they were intended: As your own personal banking system earning tax-free interest and dividends for tax-free policy loans and retirement income, plus a death benefit to leave a legacy for your heirs.

Preventing a Policy From Becoming a MEC

When you work with a Wealth Strategist at Paradigm Life, not only can we structure your whole life insurance policy to pass the “7-pay test”, they can also add on insurance policy riders. Policy riders are supplemental insurance products that can increase the benefits of your whole life insurance policy. The main rider we use to help grow wealth with insurance products is called the paid-up additions rider, or PUA rider.

The Paid-Up Additions Rider (PUA)

Prior to the creation of the paid-up additions rider and TAMRA legislature being passed, single premium policies were one of the more popular types of permanent insurance. With a single premium policy, you buy insurance with one upfront payment. The cash value for these types of policies will typically be more than 90 percent of that initial, one-time payment in the policy’s first year. The cash value of a single premium policy continues to earn interest and potential dividends each year and eventually exceeds the single premium paid, typically in year three or four.

Video: What Is a Modified Endowment Contract (MEC)? - Infinite Banking

Before TAMRA, the gains earned on the cash value of a single premium policy were tax-free. If you bought and funded a policy at a young age, the accumulated interest and dividends on it could have been substantial. Single premium policies were considered the ideal savings vehicle.

After TAMRA was passed, the gains on single premium policies became tax-deferred, not tax-free. This led to the development of the PUA rider. Including a paid-up additions rider with your whole life insurance policy is crucial if your financial goal is to grow as much cash value inside your insurance policy as possible without it becoming a Modified Endowment Contract.

A PUA rider allows you to overfund your policy right up to the line of it becoming a Modified Endowment Contract, maximizing your cash value and interest-earning potential. The majority of the PUA premium paid is immediate cash value. The idea with this type of whole life insurance policy, also known as a Wealth Maximization Account™, is to have as much cash value as possible with the lowest death benefit TAMRA will allow. This kind of policy isn’t designed for insurance coverage, it’s designed to store cash and build wealth, which are livingbenefits.

If you’ve heard that whole life insurance policies take a long time to earn cash value and receive a low rate of return, it’s because the policyholder isn’t using a PUA rider. When structured properly with a PUA rider, whole life insurance competes with market-based investments in terms of returns, but offers much more protection against market volatility.

Modified Endowment Contract (MEC) - Understand How it Benefits You (1)

Multiple Insurance Policies

The IRS has a lot of ways in which it can regulate how much money you put into savings vehicles. When it comes to qualified plans, it limits how much you can put into a 401(k), IRA, or Roth IRA. In health insurance, it limits how much you can put into a HSA or FSA. With life insurance, the IRS has created the 7-pay limit, which is a per-policy measurement.

One thing the IRS doesn’t currently regulate is how many life insurance policies you can have. That is determined by your insurance company. Insurance carriers won’t insure your life for more than you are worth, but you can hold multiple insurance policies and contribute large amounts of wealth into each.

You can also take out insurance policies on anyone whose death would affect you financially. This is called insurable interest. You can insure family members, business partners, employees, or anyone whose loss will inflict justifiable financial loss. Multiple policies within a family are collectively referred to as the family bank or private family banking. This strategy is used to grow family wealth and to create a legacy that can be passed down for generations.

Video: What Should You Understand About a Modified Endowment Contract?

Reversing a Modified Endowment Contract

In rare circumstances will you overpay your premium. Overpayment is rare, because your insurance agent should be very aware of your policy’s status, and what is necessary to avoid it from becoming a Modified Endowment Contract. Should your policy become a MEC, insurance companies will warn you of your policy’s pending status, and you’ll have two options:

  1. The insurance company can process the overpayment and notify the IRS that your policy is now a MEC.
  2. The insurance company can return the overpayment and your policy remains a non-MEC.

Once a policy becomes a Modified Endowment Contract, it will always be a MEC, which is why this change of contract is so serious.

If you’re not diligent about keeping track of your premium payments, you may be putting your policy at risk. However, if your life insurance policy is properly structured, you should never have to worry about your policy entering into a Modified Endowment Contract.

Pros and Cons of a Modified Endowment Contract

After reading about all the advantages of a whole life insurance policy compared to a Modified Endowment Contract, it might seem like a MEC is a bad thing to have. The truth is MECs are neither good nor bad; their position depends on your financial goals.

A Modified Endowment Contract doesn’t prohibit you from receiving tax advantages, it just regulates your advantages. For some people, a MEC is a beneficial financial tool. Here are some reasons why you may want to have a MEC:

  • You don’t plan on accessing you cash value until after age 59 1/2
  • You want guaranteed returns with less volatility than the stock market
  • You want to increase the tax-free death benefit your heirs receive

On the other hand, there are reasons a whole life insurance policy might be more suited to your financial goals:

  • You need liquidity (penalty-free) before age 59 1/2
  • You want to use your cash value as your own personal banking system
  • You want tax-free income in retirement

Estate Planning With a Modified Endowment Contract

If your main financial goal is to pass on the most tax-free wealth possible to your family, a Modified Endowment Contract can be a great estate planning tool. Compared to other savings vehicles like CDs or money market accounts, MECs typically earn a higher interest rate. Essentially a single premium life insurance policy, funds are placed into a MEC in one lump sum or in a series of large payments in the first few years of the policy. From there, cash value rapidly accumulates.

Regardless of how you plan to use whole life insurance, it’s imperative that your policy is structured in a way that helps you accomplish your goals. The Wealth Strategists at Paradigm Life are experts in helping people all over the United States and Canada grow and protect their wealth. Modified Endowment Contract (MEC) - Understand How it Benefits You (2) today to find the best policy for your needs.

Video: What Is The Modified Endowment Contract (MEC)? | IBC Global, Inc


What are the benefits of a modified endowment contract?

A modified endowment contract (MEC) is a designation given to cash value life insurance contracts that have exceeded legal tax limits. When the IRS relabels your life insurance policy as an MEC, it removes the tax benefits of withdrawals you can make from the policy.

How is MEC limit calculated?

To determine MEC status, the IRS uses something called a “seven-pay test,” also known as a “seven-pay limit” or “MEC limit.” During the first seven years of the policy, the cumulative amount paid toward the cash value of your policy cannot exceed the cumulative seven-pay limit for that year.

What is the 7 pay test?

The 7-pay test compares the cumulative premium paid with the net level premium (the amount necessary to pay up the policy). A policy will fail the test if, at any time during the first seven contract years, the cumulative amount paid under the contract exceeds the sum of the net level premiums.

What does MEC mean in insurance?

Simply put, paying too much in policy premiums too quickly will trigger a federal rule regarding life insurance. Your life insurance policy will be declared a “modified endowment contract” (MEC) and the tax benefits that accompany cash-value life insurance policies may be crimped.

Can you take a loan from a MEC?

Any loans or withdrawals from an MEC are taxed on a last-in-first-out basis (LIFO) instead of FIFO. Therefore, any taxable gain that comes out of the contract is reported before the nontaxable return of principal. Furthermore, policy owners under the age of 59.5 must pay a 10% penalty for early withdrawal.

How is a MEC taxed at death?

As with traditional life insurance policies, MEC death benefits aren't subject to taxation.

What happens if you surrender a MEC?

Generally, policy loans from non-MECs are not subject to income tax. But any withdrawals (including loans and partial or full surrenders) taken from the cash value of a MEC are treated as coming from earnings first and are taxed as ordinary income to the extent the policy”s cash value exceeds your basis.

Can MEC be reversed?

Nerdy tip: Once a life insurance policy becomes an MEC, the designation cannot be reversed. But if you overpay, don't panic. Your insurer will notify you and offer to refund the additional money to avoid an MEC designation.

Which of these statements describe a modified endowment contract MEC )?

The statement which describes a modified endowment contract is this: 'Exceed the maximum amount of premium that can be paid into a policy and still have it recognized as a life insurance contract. A modified endowment contract is a type of life insurance contract which has been funded with more money than allowed.

Why are endowment contracts not considered life insurance?

Why are endowment contracts NOT considered life insurance? They do not pay death benefits.

What benefit does the payer clause?

Payor Benefit — a provision under which premiums are waived if the person paying the premiums becomes disabled or dies. This option is often used when the insured is the child or spouse of the policyholder.

What happens if a modified endowment contract failed to meet the seven pay test?

A ”modified endowment” policy is a life insurance policy that has failed a “7-pay test.” The result is that all loans and cash withdrawals are taxed using the last-in first-out, or LIFO, accounting method. The 7-pay test must be passed every year.

What is a life income settlement option?

The life income settlement format provides a stream of payments that last until the beneficiary passes away. A life annuity provides a reliable source of income, but there are drawbacks. If you request settlement as life-only, your beneficiary may not be able to change to a different settlement format.

Which of the following would always be considered a modified endowment contract?

Which of the following would always be considered a Modified Endowment Contract? Single Premium Whole Life would always be a MEC as it would always fail the 7-Pay Test. Janelle is the beneficiary of a life insurance policy in which the insured has died.

What happens when a policy becomes a modified endowment contract quizlet?

If the cumulative premium payments exceed certain amounts specified under the Internal Revenue Code, the life insurance policy becomes a modified endowment contract. Taxation under an MEC is similar to taxation under an annuity. Under an MEC, the death benefit payable to the beneficiary is not subject to income tax.

How do endowment policies work?

An endowment policy is a type of investment that you take out with a life insurance company. You pay in money each month for a set period of time, and this money is invested. The policy will then pay you a lump sum at the end of the term – usually after ten to 25 years.

What is the difference between whole life insurance and endowment insurance?

The difference is that endowments have a shorter coverage period and mature sooner, usually in 10 to 20 years. Whole life policies are designed to last for the insured's whole life, so they mature when the insured policyholder reaches the age of 95 or 100. It is less likely for whole life policies to mature.

Which is better term insurance or endowment plan?

Endowment plans may have a slightly higher premium rate than term insurance since they offer both insurance and investment features. Term insurance is not a savings instrument. Endowment plans can be used for saving your earnings for the future efficiently.

Whose life is covered on a payor benefit clause?

A payor benefit clause is generally added to a life policy that insures the life of a juvenile. It provides continuance of insurance coverage in the event of the death or total disability of the individual responsible for the payment of premiums.

How is the coordination of benefits process best described?

Sometimes two insurance plans work together to pay claims for the same person. That process is called coordination of benefits. Insurance companies coordinate benefits to: Avoid duplicate payments by making sure the two plans don't pay more than the total amount of the claim.

What is payor benefit comprehensive?

Comprehensive coverage to safeguard

your child's benefit. Payor Benefit protects your child's coverage in the event that you are unable to pay the premiums as a result of a total disability or death.

What are the 5 settlement options?

What Are the Five Settlement Options for Life Insurance?
  • Lump-Sum Payment. Most people choose a lump-sum payout as their preferred life insurance settlement option. ...
  • Life Income. A life income settlement is also known as a life annuity. ...
  • Fixed Amount. ...
  • Fixed Period. ...
  • Interest Income.
Nov 11, 2021

How long will the beneficiary receive payments under the single life settlement option?

Under a single life annuity with a 10 or 15 year certain period, guaranteed monthly payments will be made to you for at least a specified number of years. (You can choose either a 10-year period or a 15-year period.) Under this form of annuity, you will receive monthly payments for as long as you live.

What is life income benefit?

The Lifetime Income Benefit Rider (LIBR) allows you to take a lifetime income from your annuity without losing control of your retirement assets. This is possible because the lifetime income is in the form of regular withdrawals from your Contract rather than annuitized payments.

What advantage does the renewability feature give to a term policy?

The renewability feature allows the coverage to be renewed for another period or another term without the insured having to provide proof of insurability, meaning that even those who have become uninsurable are guaranteed the right to renew the policy.

Which of these statements describe a modified endowment contract?

The statement which describes a modified endowment contract is this: 'Exceed the maximum amount of premium that can be paid into a policy and still have it recognized as a life insurance contract. A modified endowment contract is a type of life insurance contract which has been funded with more money than allowed.

What type of life policy covers two people and pays?

A joint life insurance policy covers two people and pays out either after one policyholder dies (first-to-die) or after both policyholders die (second-to-die or survivorship).

What happens after 20 year term life insurance?

Unlike permanent forms of life insurance, term policies don't have cash value. So when coverage expires, your life insurance protection is gone -- and even though you've been paying premiums for 20 years, there's no residual value. If you want to continue to have coverage, you'll have to apply for new life insurance.

At what age should you stop term life insurance?

Most life insurance policies have an upper age limit for applications. Many insurers stop taking life insurance applications from shoppers who are over 75 or 80, while some have much lower age limits and a few have higher limits.

What happens with life insurance at end of term?

Generally, when term life insurance expires, the policy simply expires, and no action needs to be taken by the policyholder. A notice is sent by the insurance carrier that the policy is no longer in effect, the policyholder stops paying the premiums, and there is no longer any potential death benefit.


1. Modified Endowment Contract (MEC) - Explained
(Circle of Wealth® by MoneyTrax)
2. Modified Endowment Contract (MEC) Pros and Cons
(Circle of Wealth® by MoneyTrax)
3. The Modified Endowment Contract Overview, Pros & Cons
4. Modified Endowment Contract MEC | ⭐⭐⭐⭐⭐ Google Review | Tekeno Financial
(Tekeno Financial)
5. Modified Endowment Contract: Is it Right for You?
(Retire with Purpose)

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