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.

Headshot of Rebecca Shoenthal
Headshot of Tory Crowley

By

Rebecca ShoenthalEditor & Licensed Life Insurance ExpertRebecca 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.&Tory CrowleyAssociate Editor & Licensed Life Insurance AgentTory Crowley is an associate editor and a former licensed insurance agent at Policygenius. Previously, she worked directly with clients at Policygenius, advising nearly 3,000 of them on life insurance options. She has also worked at the Daily News and various nonprofit organizations.

Edited by

Antonio Ruiz-CamachoAntonio Ruiz-CamachoAssociate Content DirectorAntonio helps lead our life insurance and disability insurance editorial team at Policygenius. Previously, he was a senior director of content at Bankrate and CreditCards.com, as well as a principal writer covering personal finance at CNET.
|

Reviewed by

Amy Northard, CPAAmy Northard, CPACertified Public AccountantAmy 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).

Updated|5 min read

Expert reviewedExpert reviewedThis article has been reviewed by a member of ourFinancial Review Council to ensure all sources, statistics, and claims meet the highest standard for accurate and unbiased advice.Learn more about oureditorial review process.

Policygenius content follows strict guidelines for editorial accuracy and integrity. Learn about our editorial standards and how we make money.

Many people who choose a permanent life insurance policy also take advantage of the tax-deferred cash value component that comes along with it. However, it’s possible to over-contribute to the cash value of your policy.

If your payments toward the cash value of your policy exceed federal limitations, your policy will no longer be considered a traditional life insurance policy. 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 details

Cash value life insurance policy

MEC

Tax-free death benefit

Yes

Yes

Surrender policy for cash

Yes

Yes

Cash value gains are tax-deferred

Yes

No

Cash value withdrawals are tax-deferred

Yes

No

Unpaid policy loans are taxable

Yes

N/A

Cash value added to your death benefit 

No

No

Collapse table

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, advanced planning manager and certified financial planner at Policygenius.

Once a life insurance policy becomes a modified endowment contract, its status cannot be reversed. However, you'll 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 licensed 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 June 20, 1988

  2. The policy does not pass the “7-pa, y 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

Year

Annual premiums

MEC status

1

$5,000

No

2

$5,000

No

3

$5,000

No

4

$5,000

No

5

$5,000

No

6

$5,000

No

7

$5,000

No

Total

$35,000

No

Collapse table

Policyholder 2: overfunded policy

Year

Annual premiums

MEC status

1

$5,000

No

2

$5,000

No

3

$5,000

No

4

$5,000

No

5

$7,500

Yes

6

$2,500

Yes

7

$5,000

Yes

Total

$35,000

Collapse table

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. 

Ready to shop for life insurance?

We don't sell your information to third parties.

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 insurance policy 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 59½ (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 59½, 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. 

More about life insurance & financial planning

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 59½, you’ll pay taxes and a 10% fee to access your money. After age 59½, 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 a short window 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.

Authors

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.

Tory Crowley is an associate editor and a former licensed insurance agent at Policygenius. Previously, she worked directly with clients at Policygenius, advising nearly 3,000 of them on life insurance options. She has also worked at the Daily News and various nonprofit organizations.

Editor

Antonio helps lead our life insurance and disability insurance editorial team at Policygenius. Previously, he was a senior director of content at Bankrate and CreditCards.com, as well as a principal writer covering personal finance at CNET.

Expert reviewer

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).

Questions about this page? Email us at .