What is a Modified Endowment Contract?

If you’ve been shopping around for life insurance, chances are you’re overwhelmed between all of the various types of life insurance. Between the terms and expressions you have to learn, the choices you have to weed through and the pitfalls you have to avoid, it can be hard to find the perfect policy for you.

While researching, one of the types of policies you might have come across is what’s known as a Modified Endowment Contract, or a MEC. This special type of policy, while similar in some respects to a standard life insurance policy, is different enough that it might need a little more explaining. 

Want too know more about what a MEC is, how it can work for you, and how it’s different from a regular insurance policy? Then read more for answers.

What is a Modified Endowment Contract?

In the simplest definition, a Modified Endowment Contract is a whole life insurance policy (not a term policy) that has had too much money put into it too quickly. That definition, however, doesn’t explain this policy very well or why it was created, so in order to fully understand the MEC, it’s necessary to have a history lesson first.

Before 1988, there was no such thing as a MEC. In those days, just like today, life insurance policies required that a certain amount of money be paid into the policy in the form of a premium every year. Unlike now, however, there was no limit to how much money the insured could actually put into the policy.

So, let’s say a policy-holder has to pay $1,000 a year in premiums according to the terms of the policy. Back before 1988, there was no rule in place stating that he or she couldn’t pay more than the required minimum amount. 

So, if it only took $1,000 a year for the policy to stay active, there was nothing to stop that person from paying well over that amount – $10,000, $20,000 or even more – during that same period of time.

Why would someone do that? Because at that time, there was no tax penalty to do so. Any money being paid into the policy was tax-free, and being drawn out of the policy later, it did not get taxed on that end, either. 

A Summary

In short, these life insurance policies became a kind of tax haven for the wealthy to hide their assets for both short-term and long-term time frames, without having to worry about paying taxes.

Because of this, life insurance policies present as a quick way to make a substantial amount of money. They generally enjoyed higher returns than a standard savings account or IRA, and it was also possible for policyholders to take out loans against the value of the policy, and then use the money from the loan to generate more wealth. 

They were seen as a way to create money from almost nothing, and it took awhile for the government to catch on to what was happening.

This all came to a stop when Congress finally realized how investors were using the system. Congress passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) with the intention that it would put an end to this sort of get-rich-quick scheming. 

Under the terms of this act, overpaying like this could change the terms of the policy, permanently transforming it from a standard life insurance policy to the newly-created Modified Endowment Contract. 

This new type of policy made these over-contributions taxable under most conditions. This effectively shut down the idea that a life insurance policy could be a haven for people simply to store wealth for the future.

The Seven-Pay Test

To determine just how much of a contribution is too much, TAMRA instituted what is known as the “seven-pay test.” This is nothing more than a guideline that states how much money can be put into a life insurance policy during its first seven years before it turns into a MEC. 

Every life insurance policy has an amount built into it, decided by the insurance company, that acts as the threshold for this test. As long as that threshold doesn’t cross within those first seven years, the policy can remain as a standard life insurance policy. If that threshold is crossed at any point during the first seven years, however, it becomes a MEC and the rules change.

The Terms of a Modified Endowment Contract

A MEC is different from a standard life insurance policy in several key areas. This means it’s very important to do your homework before deciding to purchase one.

First, the biggest difference between a MEC and a standard policy has to do with taxes and penalties. Under most standard insurance policies, you can pull out the money you put into the policy at any time. This is without fear of (most of) it requiring taxes. 

You only have to worry about being taxed once you exceed the amount of total costs put into the policy. Because at that point you tap into the gains, which are taxable income.

So, if you contribute $20,000 to a policy that has grown over the years and is now worth $35,000, the first $20k you take out does not require taxes. They treat it as if you are only dipping into the costs you paid into the policy over the years. 

Only after you withdraw all of those costs will you start to tap into the gains, which is the new money created over the life of the policy. It’s this money that brings taxes. This practice is FIFO, or “First-In-First-Out,” and protects policyholders against paying more taxes.

How an MEC Works

A MEC is just the opposite. Instead of FIFO, MECs are LIFO, or “Last-In-First-Out”. Let’s say that you have a MEC with the same amount of values as the policy above. You’ve contributed $20k over the years, but it’s worth $35k now. 

If you start to pull money out, the money is immediately taxed as income. Because you are withdrawing from the $15k gains first. After you’ve pulled out all the money made from gains, then what’s left (the final $20k) is your initial cost money, which is not taxed.

In addition to this tax change, most MECs also carry a penalty for early withdrawal. It can be as much as 10% for people under the age of 59 and a half! Once a policy holder reaches this age, however, the penalty usually goes away, but the taxation rules remain the same.

As with standard life insurance policies, MECs benefit those around after the policy holder passes away. Because of this, the rules for assets going to beneficiaries are similar to insurance policies. That money generally being tax-free unless falling under the rules and conditions of estate taxation. 

Pros and Cons of a Modified Endowment Contract

At first glance it might seem like this type of policy has a lot of cons, with very few pros. After all, you can’t take money out early without being taxed on it. And you can’t take money out if you’re too young because you’ll pay a penalty. With rules like these in place, why would someone choose to set up a policy like this?

It is true that MECS work to keep you from accessing your money as much as possible. For the short-term investor, that makes a MEC a bad choice. Long gone are the days when a life insurance policy could save you money on taxes. So, when it comes to cons, it’s definitely worth knowing what you’re getting yourself into.

First, taxes and penalties. Because taking money out of your MEC comes with taxes and early withdrawal penalties, you should not get a policy if you’re expecting to withdraw funds regularly, or at all. It’s simply not worth losing your wealth to taxes and penalties.

Another downside to the MEC has to do with taking out loans against it. In the past, people could easily take out a loan against their life insurance policy. They use the balance as collateral with no worries about charges or fees. 

MECs are different, however. When you take out a loan against a MEC, they consider it as extra income for tax purposes. This means it requires taxes as part of your yearly income.

What Are The Benefits?

However, there are a few benefits to having a MEC as well. First, it still acts as a life insurance policy. Meaning when it comes to paying out to a beneficiary after your passing. 

Just like a standard policy, the money is not taxable in this instance. So, if you have no plans to take out money from a MEC prior to your death, it becomes an excellent vehicle for passing on wealth to others.

In addition, money from a MEC is generally untouchable by creditors and the IRS. This means it’s a good way to make sure that your beneficiaries receive the full amount that they are due. Rather than one that’s diminished by various third parties.

A third reason to consider having a MEC is because they generally bring a high return on investment. So, if you have a large sum of money that you would like to see grow at a faster-than-average rate, putting it into a MEC and then leaving it alone is a pretty sure bet. 

In some cases, investors can see as much as a five-to-one return on their investment. This meaning a sum of $100,000 can be worth as much as $500,000 by the time they pass away. That money then goes straight to their beneficiaries, as mentioned above, without having to worry about creditors and taxes.

Contact Us Today!

Knowing the ins and outs of insurance can be an impossible task, especially when the rules keep changing. This is why it’s important to have someone in your corner! They can help you navigate the ins and outs of this complicated maze. 

If you would like to speak to someone about MECs, life insurance or any other type of policy, please don’t hesitate to contact us at NextGen Life Insurance today. Our team of experts is ready to listen to your needs. And develop a plan that works the best for you and your family.