What is a modified endowment contract?

When a cash value life insurance policy is overfunded and exceeds federal tax limits, it’s considered a modified endowment contract, which has specific tax consequences.

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Rebecca Shoenthal

Rebecca Shoenthal

Editor & Licensed Life Insurance Expert

Rebecca Shoenthal is a licensed life, disability, and health insurance expert and a former editor at Policygenius. Her insights about life insurance and finance have appeared in The Wall Street Journal, Fox Business, The Balance, HerMoney, SBLI, and John Hancock.

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Amy Northard, CPA

Amy Northard, CPA

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Amy Northard, CPA, is a certified public accountant and a member of the Financial Review Council at Policygenius. Previously, she served as a certification administrator for the National Association of Mutual Insurance Companies (NAMIC).

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Many people who choose a permanent life insurance policy also take advantage of the tax-deferred cash value component that comes along with it. 

But what happens if you contribute too much toward the cash value? That’s when Uncle Sam steps in.

If your payments toward the cash value of your policy exceed federal limitations, your policy is no longer considered traditional life insurance. It becomes a modified endowment contract (MEC) with serious tax implications and restrictions. MECs can be useful estate planning tools when used properly, but it’s easy to fall subject to undesired taxes and fees.

Learn how to prevent your life insurance policy from becoming an MEC, what to do if you have an MEC, and how to use an MEC to your advantage. 

Key Takeaways

  • If you have a cash value life insurance policy with high annual premiums, you could be subject to additional federal taxes

  • Term life insurance policies and other policies without cash value components are not at risk of becoming MECs

  • Any life insurance policy bought prior to 1988 is disqualified from becoming an MEC

  • After a policy is recognized as an MEC by the IRS, its status cannot be reversed

What is a modified endowment contract (MEC)?

A modified endowment contract is the term given to a cash value life insurance policy when its premiums exceed regulations set by the IRS. 

Life insurance policy vs. MEC quick comparison

Policy detailsCash value life insurance policyMEC
Tax-free death benefitYesYes
Surrender policy for cashYesYes
Cash value gains are tax-deferredYesNo
Cash value withdrawals are tax-deferredYesNo
Unpaid policy loans are taxableYesN/A
Cash value added to your death benefit NoNo

How cash value life insurance becomes a modified endowment contract

When you have a specific type of permanent life insurance policy, a percent of your monthly or annual premium goes into the cash value component, which you can access throughout your life through policy loans or withdrawals.

Every insurance company has different rules and regulations for how much you can contribute annually toward the cash value of your policy, and the IRS has its own limitations set too. If you exceed federal contribution caps, your life insurance policy becomes a modified endowment contract and won’t be able to access the cash value without penalty until age 59 ½. 

“If you’re purchasing a policy with the intention of utilizing cash value withdrawals in the future, then you’ll want to make sure to avoid MEC status,” explains Patrick Hanzel, Policygenius’ Advanced Planning Specialist and Certified Financial Planner.

Once a life insurance policy becomes a modified endowment contract, its status cannot be reversed. But, you will most likely be contacted by your insurer if a premium payment exceeds the seven-pay limit (outlined below). You’ll then be able to request a refund of the overfunded amount to keep your policy’s life insurance status or can accept the MEC designation. It’s best to discuss with your agent or financial advisor before accepting a modified endowment contract. 

Modified endowment contract rules

Modified endowment contracts are similar to retirement annuities, which guarantee monthly or annual payments for life and can supplement Social Security. The two products overlap on many tax rules, including penalties for early withdrawals. However, unlike retirement annuities, MECs retain a tax-free death benefit payout for beneficiaries (like any typical life insurance policy would). 

The IRS defines a life insurance policy as a modified endowment contract if: 

  1. The policy went in force after 6/20/1988

  2. The policy does not pass the “7-pay test,” according to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA)

  3. The policy meets the definition of “life insurance contract” as outlined in Section 7702 of the Internal Revenue Code

The seven-pay test

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. 

For example, the comparison below outlines two identical flexible premium cash value policies. Both charts represent a $500,000 policy with an annual premium limit of $5,000:

Policyholder 1: adequately funded policy

YearAnnual premiumsMEC status

Policyholder 2: overfunded policy

YearAnnual premiumsMEC status

Although both policy premiums above total $35,000 after seven years, the first policy is still considered life insurance and the second is classified as an MEC in the fifth year. 

The first policy’s owner will not be taxed if they borrow against or withdraw from their accumulated cash value, while the second policy’s owner will be taxed accordingly for any withdrawals. 

How changes to your life insurance policy affect the modified endowment contract test

After the first seven years, your cash value policy can be subjected to additional MEC limit tests if you alter the policy amount, add on certain riders, or make other changes as outlined in your policy. 

When you have a cash value permanent life insurance policy (or really any life insurance policy) it’s important to consult with your agent before making any changes to your policy. Your agent may recommend buying additional life insurance instead of altering your existing plan. 

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Tax consequences under a modified endowment contract

Withdrawing money from a modified endowment contract is similar to withdrawing from a non-qualified annuity, which is funded with post-tax dollars. When you take money out of your MEC, the earnings are taxable as ordinary income before you turn 59 ½ and you also incur a 10% penalty. After age 59 ½, you’ll still face taxes on withdrawals, but no penalties. This differs from a qualified annuity, such as an IRA or 401(k), which is instead funded with pre-tax dollars.

“A whole life policy that becomes an MEC can still grow cash value, but withdrawals could be subject to taxes and/or penalties,” explains Hanzel. 

Also death benefits for MECs, like traditional life insurance policies, are not subject to taxes.

Is it smart to keep a policy that becomes a modified endowment contract?

If you unintentionally overfunded your whole life insurancepolicy and it becomes an MEC, it doesn’t necessarily mean you should cancel your policy. A modified endowment contract can still be useful for estate and retirement planning

Estate planning

Similar to second-to-die (survivorship) life insurance policies, MECs pay out to heirs when both partners insured in the policy have passed away. The money can cover estate taxes so your beneficiaries won’t have to. 

Retirement planning

If you don’t need to withdraw from the cash value before age 59 ½ (thus incurring penalties), an MEC can be an alternative way to build retirement funds that you can use later. You’ll still have to pay income taxes on whatever you take out after age 59 ½, so it’s best to speak to a financial advisor to see what’s best for your situation.

The average person looking for a life insurance product to replace their income and protect their loved ones is better off getting a term life insurance policy instead. But a modified endowment contract can be useful for some people to help cover estate taxes. 

Frequently asked questions

What happens when a policy becomes a modified endowment contract?

When a permanent life insurance policy becomes an MEC, you can no longer make tax-free withdrawals from the cash value. Before age 59 ½ you’ll pay taxes and a 10% fee to access your money. After age 59 ½ you’ll still pay taxes, but with no additional penalty.

Can a modified endowment contract be reversed?

If you accidentally overfund your policy’s cash value, you may have the chance to refund the premium payments. After that, a policy's MEC status cannot be reversed.

How do you avoid a modified endowment contract?

Talk to your life insurance company or independent agent to make sure your annual policy premiums do not exceed federal tax limitations to avoid an MEC.