Why is a mec bad?

To better explain a modified endowment contract, let's go back to decades ago, when whole life insurance policies were all the rage. Term life insurance is in effect for a set number of years, but whole life insurance provides coverage throughout a person's life, as long as they pay their premiums as agreed. What really set whole life apart was that it was cash value life insurance. Part of each premium went toward cash value that the policyholder could withdraw or borrow against.

Better yet, the cash paid into whole life policies earned a guaranteed rate of interest -- and a slew of tax advantages that made them safe havens. Keenly interested in investments that minimize taxes, policyholders put large sums into whole life policies. They got to protect their money from the IRS, and have a death benefit to help their beneficiaries get by if the policyholder died.

Eventually, lawmakers caught on that insurance companies were advertising whole life policies as a way to build cash value without paying regular tax rates. Congress was appalled that life insurance companies had created a tax-sheltered investment.

In 1988, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA), which put strict limits on how much could be paid into an insurance policy. And under the act, any over-funded policy would be moved into a new category -- a modified endowment contract.

Properly funded policies could remain whole life and keep sweet perks like:

But once a policy owner pays too much into a life insurance policy, it becomes a modified endowment contract, and the tax rules change. They look like this:

There is no single answer to when a life insurance contract becomes a modified endowment contract. The switch is based upon factors like the age of the policyholder and the face amount (death benefit) of the policy.

If the goal of a policyholder is to prevent a policy from becoming an MEC, it is important to understand the limits of the policy and to be careful about how much gets paid into it. As far as the government is concerned, it all boils down to the "7 pay test."

The 7 pay test (sometimes called the "seven pay test" or "7 pay limit") determines when a policy becomes a modified endowment contract. In short, the 7 pay test calculates the amount paid in during the first seven years of the contract. As long as that amount stays below a specific threshold, all is well. Once it exceeds that threshold, the policy becomes a modified endowment contract.

Once a policy converts to a modified endowment contract, it cannot be reversed.

The best insurance companies let a policyholder know when the cash in their life insurance policy gets dangerously close to the limit. Typically, a policyholder receives notification warning them that too much has been paid in. If the policyholder does nothing about the problem, the insurer informs the IRS that the life insurance policy has converted to a modified endowment contract. If the policyholder is determined to prevent the policy from becoming a modified endowment contract, they can request a refund of the overpayment from the insurer.

A policy that becomes a modified endowment contract loses the special tax treatment associated with whole life policies.

The IRS treats a modified endowment contract like other investments. That means the policyholder may be penalized for accessing funds before the age of 59 1/2, and will pay taxes on earnings, just like most other investments.

If the policyholder receives notification from their insurance company that they are on the edge of entering modified endowment contract status, the easiest way to make sure nothing changes is to request a refund of overpaid funds.

If the policyholder decides that a modified endowment contract is a better fit for their financial goals, there's nothing they need to do; the overpaid policy will convert.

There are several reasons a person may want to allow a whole life policy to become a modified endowment contract. With planning, an MEC can:

However, if you put too much money intoto your life insurance cash value account, the government could turn your life insurance policy into a modified endowment contract (MEC).

If your life insurance policy becomes an MEC, your life insurance coverage will not change. However, MECs can be taxed at 10% for early cash value withdrawals. That’s different from cash value accounts, which do not have a penalty for withdrawals.

The Internal Revenue Service (IRS) converts a life insurance policy into a modified endowment contract if the policy was issued on or after June 21, 1988, and if you exceed the IRS’ contribution limits. The IRS’ “seven-pay test” determines these contribution limits.

The seven-pay test is an IRS system used to decide whether you have overfunded your cash value life insurance. Your insurance company gives you a limit for how much money you can pay into your life insurance account each year. This limit depends on how much money it would take to pay out your policy over the next seven years.

Life insurance policyholders may want to overpay on their policy to boost the holdings in their cash value account and increase the amount they’ve invested. But if you pay over the annual limit within the first seven years, you would fail the seven-pay test, and the IRS could convert your life insurance policy into a MEC.

You can only overpay in the first seven years of a life insurance policy. However, if you significantly change your policy by adding a rider or increasing the death benefit, the seven-year period will start over again. That’s because life insurance riders and changes to your death benefit alter the cost and value of the policy.

You may wonder how MECs differ from life insurance in practice. An MEC maintains the benefits of a life insurance policy but will be taxed for early withdrawals.

“Despite losing some of the tax benefits of a cash value life insurance policy, MECs could have a positive impact on your financial planning,” says Mark Friedlander, a spokesperson for the Insurance Information Institute. He highlights that “MECs can function as an alternative or supplement to annuities in your retirement and estate planning.”

You may want to consider the specific advantages and disadvantages of MEC insurance.

Your life insurance company will typically notify you that you’ve overpaid on your policy and that you’ll have to reclaim the additional money within a particular window to avoid MEC status. If you don’t take out the money within that window, the IRS could redesignate your policy as MEC life insurance.

If you want to increase the cash value and death benefit and ensure that you don’t overfund your account, you can purchase a paid-up additional rider (PUA). The money you pay into a PUA rider may earn dividends along with the rest of your policy.

Speak with an insurance advisor if you have questions about your policy. Knowing the annual cap on contributions to your life insurance policy will help you avoid MEC status.

In a nutshell, if your life insurance contract becomes a MEC, you'll lose all the life insurance policy tax benefits that are otherwise available prior to payment the death benefit. That is a huge ugly deal for many people that invested in a permanent life insurance policy.