Life insurance is a contract between you and a life insurance company to guarantee your survivors a sum of money upon your death, provided that all of the premiums are paid and the policy is still in force. However, with permanent life insurance, some of the policy proceeds can be accessed while you are still alive. For this to happen, the policy must not become a MEC.
MEC stands for "modified endowment contract." An MEC is created when a life insurance policy fails to meet IRS guidelines concerning the seven-pay test or the cash value accumulation test. These tests dictate how much premium can be paid into a policy and how quickly the cash values can build up inside of a cash value policy before the policy is no longer treated as a life insurance policy. The insurance industry often shows what is called an "MEC guideline" in policy illustration software that allows the insurance agent to easily avoid creating an endowment contract for his clients. An MEC will lose most of the tax benefits associated with life insurance, which is why many individuals choose to avoid creating an MEC.
To prevent your life insurance policy from becoming an MEC, you must not fund your life insurance policy with more premium than is allowed by law. The policy must pass a seven-pay test or a cash value accumulation test (CVAT). If you fund the contract with more premium than is necessary to keep the policy in force over any seven-year period, the life insurance policy fails the seven-pay test. Alternatively, you can use the CVAT test which dictates that there must be a "corridor" or "net amount at risk" of a certain percentage that is dictated by your age for the policy to be considered life insurance. The "net amount at risk" is the amount of insurance that is being purchased. This is the amount between the death benefit and the cash surrender value of the policy.
With the loss of tax advantages associated with an MEC, there are a few benefits. First, because it is no longer considered life insurance, the policy can be funded with as much premium as you want. Cash value accumulation is normally much stronger in a modified endowment contract than in a life insurance policy.
A common misconception regarding MECs is that the policy can be reversed in the future. An MEC is not reversible. Another common misconception is that the cash value and death benefit are no longer income tax-free. While the major advantage of a life insurance policy has been removed, i.e., tax-free access to cash values, the cash value will continue to grow income tax-deferred inside the policy. However, you will not be able to access the cash value until age 59-1/2 without incurring a penalty for early withdrawal if the policy is an MEC. In this way, it works similar to an annuity contract. The death benefit proceeds are also income tax-free.
Before allowing your policy to become an MEC, you need to make sure you have weighed the pros and cons. Since an MEC cannot be reversed, you need to understand that you are losing the tax advantages associated with a life insurance policy and that you will be left with, essentially, a life insurance policy that functions more as a non-qualified retirement account than a life insurance contract.
- "Life &amp; Health Insurance, License Exam Manual, 6th Edition;" Dearborn Financial; 2004
- "Ernst &amp; Young&#039;s Personal Financial Planning Guide, 5th edition;" Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- "Practicing Financial Planning for Professionals, practitioner&#039;s 10th edition;" Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- USAA: What is a MEC?