What Is a Modified Endowment Contract?

What is a Modified Endowment Contract, and what does it have to do with life insurance?

If you’re using Infinite Banking as a savings tool, you want to avoid having your policy become a MEC. But what exactly are Modified Endowment Contracts? How does it change the taxation on your life insurance policy? Why does it exist? And when might you want to use a MEC? 

If you want to know more about how to use Infinite Banking to accomplish your financial goals… tune in now!

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Defining the Modified Endowment Contract

There are a lot of great reasons to have a whole life insurance policy. This includes tax advantages, uninterrupted compounding growth, and income protection. It’s the ideal vehicle for an infinite banking strategy–however, you can lose these benefits if you over-fund your policy. 

When you put too much money into a whole life insurance policy, it becomes something called a Modified Endowment Contract. When a policy becomes a MEC, it loses its tax advantages. The IRS created this legislation to cut down on what they deemed taking advantage of life insurance.

The original purpose of life insurance’s tax advantages was to incentivize people to buy insurance. That’s because life insurance can protect families financially from a loss of income during a difficult time. This also prevents the government from having to commit tax dollars toward supporting these families. The government first implemented these benefits with a specific purpose in mind: to be a win for families. They didn’t create the advantages as a loophole.

In order to protect the original intent of life insurance—to provide a death benefit—the IRS decided that if policyholders didn’t follow certain guidelines, it would functionally be classified as an investment, rather than an insurance policy. 

How MECs Work

Let’s consider an example. Say you want to buy a life insurance policy with a $1 million death benefit. The least you can pay, or the “floor,” is going to be term insurance. This is the cheapest premium you can have, however, you only have the temporary death benefit and nothing more. 

What you can pay on a million-dollar policy, however, is a sliding scale. You can have different life insurance products or structures that change the premium. For example, you can have whole life insurance, structured in a few different ways. Typically, the higher your premium, the more benefits you get, including living benefits like a cash value account. 

A whole life insurance policy structured for infinite banking is at the top of this scale. Largely because of all the living benefits. Tax favorable growth, uninterrupted compounding interest, tax-free access via policy loans—these are just a few benefits, on top of your permanent insurance. 

The MEC rule creates an official “cap” to the sliding scale, preventing people from paying beyond the maximum, as they were prior to the late 80s. Now, if you go through the pay ceiling, you still have life insurance, but it will no longer have the same tax treatment.

The Tax Consequences of a MEC

With a MEC, your death benefit still passes to your heirs tax free, however, your living benefits no longer receive the same tax advantages. If you take a policy loan with a MEC contract, you will have to pay income taxes on that money. Additionally, if you withdraw money from your cash value before age 59 ½ you will be subject to penalties. 

A MEC policy gets similar treatment as a 401(k) or an IRA. If you are choosing to use whole life insurance primarily as a savings tool, or as an infinite banking policy, it’s important that you don’t MEC your policy. 

The 7-Pay Test

In order to determine what policies are a MEC, the IRS uses something called the 7-pay test. Essentially, to keep a policy from becoming a MEC, one must pay premiums for at least 7 years. In addition, the death benefit must be suitable for the premium, as calculated by actuaries.

In other words, if you over-fund in less than 7 years, you policy becomes a MEC. For example, single-premium life insurance policies will always be a MEC, because they’re over-funded within the 7-year time frame.

This 7-year window can also start over any time there’s a material change. A material change is an event that increases the death benefit of your policy beyond its normal growth. If you have a convertible term insurance rider, for example, and then you convert the term later, the 7-year window starts over. 

The specific calculations can be complicated, and even now the MEC limits are changing under the updated 7702 rule. However, when you buy a policy with a mutual life insurance company, they send reminders if you over-fund your policy. In other words, you won’t MEC your policy accidentally–your insurance company will give you a heads up.

Is There An Upside to Having a MEC?

There’s not necessarily a benefit to having a MEC, however, it’s not always a bad thing to MEC a policy.

While a MEC changes the tax treatment of the living benefits, the death benefit of a MEC still passes tax free to heirs. If you don’t foresee leveraging your living benefits and want to maximize your legacy in a short time frame, you might not mind having a MEC. This is especially true if you’re funding a policy later in life, and feel like you’re catching up.

The premiums you pay translate directly to cash value growth, and the cash value is the accessible portion of your death benefit. So when you over-fund the policy, you can also drive up the overall death benefit. It’s just an inefficient way to do things if you hope to use your cash value for life insurance loans. 

The real takeaway from this is that any policy has the potential to become a Modified Endowment Contract if it’s not watched over carefully and funded correctly.

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Do you want to coordinate your finances so that everything works together to improve your life today, accelerate time and money freedom, and leave the greatest legacy? We can help!  Book an Introductory Call with our team today https://themoneyadvantage.com/calendar/, and find out how Privatized Banking, alternative investments, or cash flow strategies can help you accomplish your goals better and faster. That being said, if you want to find out more about how Privatized Banking gives you the most safety, liquidity, and growth… plus boosts your investment returns, and guarantees a legacy, go to https://privatizedbankingsecrets.com/freeguide to learn more.