A modified endowment contract is another name for a permanent life insurance policy that’s been overfunded. Permanent life insurance policies are typically funded over decades of premium payments — the coverage is designed to last for your entire life. But if your payments toward the cash value of your policy exceed federal limitations, your policy becomes a modified endowment contract (MEC) according to the IRS. This causes you to lose some of the tax breaks you’d typically get for withdrawals from your cash value.
MECs can be useful estate planning tools when used properly, but it’s easy to fall subject to undesired taxes and fees.
How does cash value life insurance become a modified endowment contract?
Cash value life insurance policies can become modified endowment contracts if you overpay in premiums.
When you pay premiums for your permanent life insurance policy, a portion of each payment funds your cash value account, which you can access throughout your life through policy loans or withdrawals. Your cash value earns interest over time.
Many permanent policies allow you flexibility regarding how much you can contribute at a time. You may be able to increase your premiums as long as you can afford it.
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.
Typically, you can withdraw from your cash value tax-free, but if you exceed federal contribution caps, this benefit is retracted.
If your life insurance policy becomes a modified endowment contract, you won’t be able to access the cash value without penalty until age 59 ½.
An overfunded life insurance policy may become an MEC only during the first seven years of the life of the policy. However, after the seventh-year mark, an overfunded policy may risk receiving MEC status only if you make changes to the policy’s benefits.
“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.
Most of the time, you’ll set your payment schedule with your life insurance agent when you purchase your policy to ensure this doesn’t happen. For your policy to become an MEC, you typically need to overpay by thousands of dollars.
Once a life insurance policy becomes a modified endowment contract, its status can’t be reversed. You’ll most likely be contacted by your insurer if your policy becomes overfunded and is at risk of receiving MEC status.
Before your policy’s MEC status is irreversible, you’ll be able to request a refund of the overfunded amount to keep your policy’s life insurance status, or you can accept the MEC designation. Generally, it’s best to consult with a licensed agent or financial advisor before accepting a modified endowment contract.
Learn more: Do you need to die to collect life insurance?
How to request a refund to keep your policy’s life insurance status
Your insurer should notify you — either by mail or your indicated preferred contact method — if your policy is at risk of becoming an MEC.
If you suspect your policy’s status might change after paying a recent premium, you can contact your insurer first.
Your insurer will direct you to fill out any necessary paperwork regarding the status of your life insurance policy.
The insurer can then refund your excess premiums within 60 days of the end of your policy’s contract year to prevent your policy from becoming an MEC.
For instance, let’s say your policy went into effect on May 1, 2022 — that means your first contract year runs from May 1, 2022 until May 1, 2023. If you overfund your policy in May of 2023, you can elect to receive the refund either before May 1, 2024, or within 60 days following that date.
After the first seven years, your cash value policy can still be subjected to additional MEC limit tests if you change your coverage, add on certain riders, or make other changes as outlined in your policy. The same rules apply — you’ll just want to contact your insurer within 60 days of the end of your current contract year.
Life insurance policy vs. MEC
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 |
Modified endowment contract rules & regulations
Modified endowment contracts have similar tax rules as retirement annuities, which guarantee monthly or annual payments for life and can supplement Social Security. The two products overlap on some tax regulations, 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:
The policy went in force after June 20, 1988.
The policy does not pass the “seven-pay test,” according to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). [1]
The policy meets the definition of “life insurance contract” as outlined in Section 7702 of the Internal Revenue Code. [2]
What is 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 seven-pay limit for that year.
The IRS sets limits based on how much it would cost to pay for your policy in full. So, if you buy a permanent life insurance policy and pay for it in full in under seven years (instead of paying for it over the course of decades), it becomes an MEC.
If your policy is overfunded after year seven, it doesn’t risk becoming an MEC — unless you make changes to your policy. If you, for example, increase the death benefit or add riders to your policy, then it may become subject to additional MEC tests again.
Example of an overfunded life insurance policy becoming an MEC
The comparison below outlines two identical flexible premium cash value policies. Both charts represent a $250,000 policy with an annual premium limit of $15,000. This means you can’t contribute more than $15,000 to your policy per year for the first seven years it’s active.
The first chart shows how a policy that’s been adequately funded for the first seven years won’t be at risk of receiving MEC status.
The second chart shows how a policy that’s been overfunded in the fifth year has received irrevocable MEC status — even if the overall contribution in the initial seven-year period is the same as the policy adequately funded.
Adequately funded life insurance policy
Year | Annual premiums | MEC status |
|---|---|---|
1 | $15,000 | No |
2 | $15,000 | No |
3 | $15,000 | No |
4 | $15,000 | No |
5 | $15,000 | No |
6 | $15,000 | No |
7 | $15,000 | No |
Total | $105,000 | No |
Overfunded life insurance policy
Year | Annual premiums | MEC status |
|---|---|---|
1 | $15,000 | No |
2 | $15,000 | No |
3 | $15,000 | No |
4 | $15,000 | No |
5 | $17,500 | Yes |
6 | $12,500 | Yes |
7 | $15,000 | Yes |
Total | $105,000 | Yes |
Although both policy premiums above total $105,000 after seven years, the first policy is still considered life insurance while the second one is classified as an MEC in the fifth year.
The first policy’s owner won’t 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.
What are the tax consequences of 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 of Policygenius.
The death benefit for an MEC works the same as a traditional life insurance policy — when you die, your beneficiaries won’t have to pay taxes on the proceeds, save for a few rare exceptions.
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: MECs pay out to the beneficiaries when the insured person dies. The proceeds can be used to cover estate taxes so your heirs won’t have to cover them.
Retirement planning: If you don’t need to withdraw from your cash value before age 59 ½, an MEC can serve as an alternative way to build retirement funds. You’ll still have to pay income tax on withdrawals after age 59 ½, so it’s best to consult a financial professional before using this strategy.
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 window — a year or less, depending on when your policy’s contract year starts — to refund the premium payments. After that, a policy’s MEC status cannot be reversed.
How do you avoid a modified endowment contract?
To avoid an MEC, you can meet with your life insurance company or agent to make sure your annual policy premiums don’t exceed federal tax limitations.
Can changes to your policy affect whether or not it qualifies as a modified contract?
After the first seven years, your cash value policy can be subjected to additional MEC limit tests if you change your coverage, add on riders, or make other changes as outlined in your policy. It’s best to consult a financial professional or your life insurance agent before making any major changes to your policy.
