One of your financial goals may be building your life insurance policy’s cash value account. Permanent life insurance policies—including whole life insurance—typically have cash value components that earn tax-free interest or investment returns. If that cash value account builds up enough value, you can pay your premiums with the money and borrow against it.
However, if you put too much money intoto your life insurance cash value account, the government could turn your life insurance policy into a modified endowment contract (MEC).
If your life insurance policy becomes an MEC, your life insurance coverage will not change. However, MECs can be taxed at 10% for early cash value withdrawals. That’s different from cash value accounts, which do not have a penalty for withdrawals.
How Is a Modified Endowment Contract Determined?
The Internal Revenue Service (IRS) converts a life insurance policy into a modified endowment contract if the policy was issued on or after June 21, 1988, and if you exceed the IRS’ contribution limits. The IRS’ “seven-pay test” determines these contribution limits.
What Is the Seven-Pay Test?
The seven-pay test is an IRS system used to decide whether you have overfunded your cash value life insurance. Your insurance company gives you a limit for how much money you can pay into your life insurance account each year. This limit depends on how much money it would take to pay out your policy over the next seven years.
Life insurance policyholders may want to overpay on their policy to boost the holdings in their cash value account and increase the amount they’ve invested. But if you pay over the annual limit within the first seven years, you would fail the seven-pay test, and the IRS could convert your life insurance policy into a MEC.
You can only overpay in the first seven years of a life insurance policy. However, if you significantly change your policy by adding a rider or increasing the death benefit, the seven-year period will start over again. That’s because life insurance riders and changes to your death benefit alter the cost and value of the policy.
MECs vs. Life Insurance
You may wonder how MECs differ from life insurance in practice. An MEC maintains the benefits of a life insurance policy but will be taxed for early withdrawals.
“Despite losing some of the tax benefits of a cash value life insurance policy, MECs could have a positive impact on your financial planning,” says Mark Friedlander, a spokesperson for the Insurance Information Institute. He highlights that “MECs can function as an alternative or supplement to annuities in your retirement and estate planning.”
You may want to consider the specific advantages and disadvantages of MEC insurance.
Pros of a modified endowment contract
- A life insurance policy that becomes a modified endowment contract still leaves a tax-free benefit to your life insurance beneficiary or beneficiaries.
- You will also continue to get guaranteed returns with less volatility than the stock market.
Cons of a modified endowment contract
- You cannot convert a policy that becomes a modified endowment contract back into a standard life insurance policy.
- You’ll pay a 10% tax penalty on cash value withdrawals before the age of 59.5.
Related: The Truth About Endowment Life Insurance Policies
How to Avoid MEC Status
Your life insurance company will typically notify you that you’ve overpaid on your policy and that you’ll have to reclaim the additional money within a particular window to avoid MEC status. If you don’t take out the money within that window, the IRS could redesignate your policy as MEC life insurance.
If you want to increase the cash value and death benefit and ensure that you don’t overfund your account, you can purchase a paid-up additional rider (PUA). The money you pay into a PUA rider may earn dividends along with the rest of your policy.
Speak with an insurance advisor if you have questions about your policy. Knowing the annual cap on contributions to your life insurance policy will help you avoid MEC status.
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Modified Endowment Contract FAQ
Are there tax penalties when cashing in a life insurance policy?
If you choose to surrender your own permanent life insurance policy for the cash value, you could be taxed on the portion of the cash value that exceeds the premiums you paid in. This portion represents investment gains and is taxed as income.
Related: Is life insurance taxable?
What are the tax consequences of a policy loan on a whole life insurance policy?
You typically won’t have to pay taxes on a whole life insurance policy loan as long as the policy is in force. But if the policy ends before you pay the loan back, expect to pay a tax bill for the amount of the loan that exceeds what you paid in premiums.
Modified endowment contract loans, however, are taxed.
Which life insurance policies come with cash value accounts?
Permanent life insurance policies including whole life insurance, variable life and universal life insurance typically come with cash value accounts.
Term life policies, on the other hand, do not come with cash value accounts.
Related: Cash value life insurance explained
