Your permanent life insurance policy could become a modified endowment contract if you overfund its cash value, but there are ways to avoid it.
Updated Apr 30, 2024 · 2 min read Written by Georgia Rose Lead Writer Georgia Rose
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Georgia Rose is a lead writer on the international team at NerdWallet. Her work has been featured in The Washington Post , The New York Times, The Independent and The Associated Press . Throughout her career, Georgia has written on a variety of subjects, including personal finance, government policy, science and technology. She enjoys researching complex topics and distilling the information for her readers. Before joining the international team, she wrote for the insurance vertical, specializing in life insurance.
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Tony Steuer is a financial wellness advocate, podcaster and speaker, and the author of "Questions and Answers on Life Insurance." His advice has been featured in media outlets including The New York Times, The Washington Post, Fast Company, Forbes and CNBC. He has a bachelor of science degree in finance from California State University and holds the following designations: Chartered Life Underwriter (CLU), Life and Disability Insurance Analyst (LA) and Certified Personal and Family Finance Educator (CPFFE).
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If you own a permanent life insurance policy such as whole life, you’ll likely be aware of its cash value. A portion of your l i f e i nsurance premium is allocated to the cash value, which grows tax-deferred. Although it sounds great, this tax break comes with an asterisk.
If you overfund the account by contributing too much money toward its cash value, the policy could become a modified endowment contract, or MEC. While your life insurance coverage won’t change, you could face additional taxes and penalties for withdrawing money early. But you can avoid the designation if you understand how and when MEC rules apply.
A modified endowment contract is a life insurance policy that has exceeded contribution limits set by the IRS. [0]
Internal Revenue Service . Section 7702 — Life Insurance Contract Defined. Accessed Apr 30, 2024.The IRS will declare a life insurance policy to be an MEC if both of the following statements are true:
The policy was issued on or after June 21, 1988. The policy does not pass the “7-pay test.”The 7-pay test is what the IRS uses to verify whether a cash value life insurance policy has been overfunded. These policies typically have an annual limit on how much you can pay into the account. This limit is based on the amount of premiums it takes for the policy to be fully paid up in the first seven years. To be fully paid up means the coverage is paid for in full and no more premiums are required to keep the coverage active. Policyholders sometimes pay more than the minimum premium because the additional money goes to the cash value and may boost it. However, if at any point within the first seven years you pay more than the annual limit, the policy will fail the 7-pay test and could be designated an MEC.
For example, if your policy’s annual premium limit is $1,000, and you pay $2,000 in the second year of owning it, it would trigger an MEC conversion.
Once a life insurance policy becomes an MEC, the designation cannot be reversed. But if you overpay, don’t panic. Your insurer will notify you and offer to refund the additional money to avoid an MEC designation. The excess premiums must be returned to you within 60 days after the end of your policy’s contract year to prevent the policy from failing the 7-pay test.
The 7-pay test applies to the first seven years of a policy being active. However, if you make material changes to your coverage, the clock gets reset for another seven years. A material change is something that alters the coverage, such as increasing the death benefit or adding a life insurance rider .
Modified endowment contracts are still life insurance policies, though a different type of contract. The death benefit remains intact, which means your life insurance beneficiaries will still receive the payout when you die. And the cash value account still grows tax-deferred. However, when you withdraw funds from a modified endowment contractn MEC, you may be subject to more taxes and fees than with a typical life insurance policy.
This is because the withdrawals from an MEC are treated differently by the IRS. Ordinarily, when you take money from a life insurance policy , the “policy basis” is withdrawn first. The basis is the amount you’ve contributed through your premiums, and you can withdraw it tax-free. So, if you don’t take out more than the basis, you won’t be taxed. Under a modified endowment contract, the gains are withdrawn first, which are taxed as ordinary income.
MEC withdrawals also typically incur a 10% tax penalty if you take out the money before turning 59½ years old. The 10% applies only to the gains, but because the gains are withdrawn first, you’ll likely pay the penalty.
You may come across the term “paid-up additions,” or PUA, when researching modified endowment contracts. A PUA rider essentially allows you to add small amounts of permanent life insurance funded by dividends. Policyholders can use PUAs to increase the policy's overall life insurance death benefit and cash value, while maintaining the correct ratio of insurance to investment, and avoid an MEC conversion.
If your policy is designated an MEC, it doesn’t necessarily equal disaster. The MEC rules were created to prevent policyholders from using life insurance policies as tax-free investment havens. If you don’t plan on withdrawing the money early, you could heavily fund the account and take advantage of the tax-deferred growth for retirement or estate planning purposes.
However, if you want to withdraw or borrow against the cash value before retirement, you’ll want to avoid MEC status.
Talk to a life insurance agent or broker before making any permanent investment decisions with your life insurance policy.
Permanent life insurance
Modified endowment contract
Death benefit payout
Tax-deferred cash value growth
Gains subject to income tax
Order of withdrawals
Policy basis first.
Tax penalties for early withdrawals
Yes, 10% penalty on the withdrawal of gains before age 59½.
* Permanent life insurance typically lasts until a maximum age such as 95, 100 or 120.
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Georgia Rose is a lead writer on the international team at NerdWallet. Her work has been featured in The New York Times, The Washington Post, The Independent and ABC News. See full bio.
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