Modified Endowment Contracts (MECs) Flashcards
Modified Endowment Contracts (MECs)
Prior to 1988, individuals could place large sums of money into a cash value policy, typically in a lump sum, and the cash would grow tax deferred until the insured died at which point a death benefit paid income tax free.
Or if they needed cash, they could take a tax-free lifetime loan or withdrawal. These policies were used in place of investment vehicles to avoid paying taxes.
Under current law, if a policy is funded too quickly, it is classified as a Modified Endowment Contract or an MEC. MEC rules impose stiff penalties to eliminate the use of life insurance as a short term savings vehicle.
7-Pay Test
When a contract does not pass the 7-pay test, it is deemed a MEC. The 7-pay test is a limitation on the total amount that can be paid into a policy in the first 7 years.
If a policyowner pays premiums in excess of the guidelines, the excess premium can be refunded by the insurer within 60 days after the end of the contract year.
The other types of policies that could be classified as MECs are flexible premium policies such as Universal and Variable universal life.
The flexible premium feature allows the owner to pay premiums on their own schedule.
Once a policy is classified as a MEC, it maintains that classification for the life of the policy.
The overfunding cannot be undone in future years.
Taxation on MECs
If a contract is deemed to be a MEC, then any funds that are distributed are taxed on a “last-in, first-out” (LIFO) basis, rather than the normal “first-in, first-out” tax treatment.
That means for income tax purposes the first money out of the annuity will be considered as earnings, not principal, and will be taxed as ordinary income when withdrawn from the contract.
Penalties on MECs
If the contract is a MEC, all cash value transactions are SUBJECT TO TAXATION and penalty. Funds are subject to a 10% penalty on gains withdrawn prior to age 59 ½. This is considered a premature distribution.
Distributions made on or after age 59 1/2, and distributions paid out due to death or disability, are not subject to the penalty
