Key takeaways. A modified endowment contract (MEC) is a cash value life insurance policy that gets stripped of many tax benefits. The seven-pay test determines if the policy qualifies as an MEC. MECs ended a popular way to shelter money from taxes by borrowing from insurance policies whose cash value grew too quickly.
- 1 What happens when a life insurance policy becomes a MEC?
- 2 What is MEC limit in insurance?
- 3 Is a MEC bad?
- 4 Is a modified endowment contract good?
- 5 Is the death benefit of a MEC taxable?
- 6 Does a MEC automatically lapse?
- 7 What qualifies as a MEC?
- 8 What is a modified whole life policy?
- 9 Is a partial withdrawal from life insurance taxable?
- 10 Which type of life insurance policy is best suited for paying off?
- 11 What is considered a limited pay life policy?
- 12 What is the aleatory nature of an insurance contract?
- 13 Can you borrow from a MEC?
- 14 How do you reverse a MEC?
- 15 How are MEC policy loans taxed?
What happens when a life insurance policy becomes a MEC?
When a permanent life insurance policy becomes an MEC, you can no longer make tax-free withdrawals from the cash value. Before age 59 ½ you’ll pay taxes and a 10% fee to access your money. After age 59 ½ you’ll still pay taxes, but with no additional penalty.
What is MEC limit in insurance?
This is called the 7-pay limit or MEC limit, and is based on rules established by the Internal Revenue Code, setting the maximum amount of premium that can be paid into the contract during the first seven years from the date of issue in order to avoid MEC status.
Is a MEC bad?
Pros and Cons of a Modified Endowment Contract After reading about all the advantages of a whole life insurance policy compared to a Modified Endowment Contract, it might seem like a MEC is a bad thing to have. The truth is MECs are neither good nor bad; their position depends on your financial goals.
Is a modified endowment contract good?
Modified endowment contracts work best for investors who do not plan on making withdrawals before turning 59.5, else they get hit with the same tax and 10 percent penalty applied to early withdrawals from an individual retirement account or 401(k).
Is the death benefit of a MEC taxable?
As with traditional life insurance policies, MEC death benefits aren’t subject to taxation.
Does a MEC automatically lapse?
Once a flexible premium cash value life insurance policy becomes classified as an MEC, it immediately loses its former tax benefits, and this transformation is irreversible. A MEC cannot become a life insurance policy ever again, regardless of circumstances.
What qualifies as a MEC?
A modified endowment contract (MEC) is a designation given to cash value life insurance contracts that have exceeded legal tax limits. When the IRS relabels your life insurance policy as an MEC, it removes the tax benefits of withdrawals you can make from the policy.
What is a modified whole life policy?
A version of a whole life insurance policy where the insured pays less premium than usual for an agreed upon amount of time. After that period of time the premium payments increase to an agreed upon amount that is higher than usual for the life of the policy.
Is a partial withdrawal from life insurance taxable?
When You Make a Partial Withdrawal From the Cash Value of Permanent Insurance. While you’re still living, you can make a partial withdrawal from the cash value portion of your policy, and this amount is not taxable.
Which type of life insurance policy is best suited for paying off?
A permanent policy’s cash value grows over time and can be used to pay premiums or take out a loan from the insurer. Since permanent life insurance policies have much higher rates than term policies, and most financial obligations go away over time, term life insurance is typically the better option for most people.
What is considered a limited pay life policy?
Limited pay life insurance is for an individual who owns a whole life insurance policy but chooses to pay for the total cost of their premiums for a limited number of years. With the limited pay life insurance option, you pay premiums in the first 10, 15, or 20 years of ownership, but the benefits last a lifetime.
What is the aleatory nature of an insurance contract?
In insurance, an aleatory contract refers to an insurance arrangement in which the payouts to the insured are unbalanced. Until the insurance policy results in a payout, the insured pays premiums without receiving anything in return besides coverage.
Can you borrow from a MEC?
Any loans or withdrawals from an MEC are taxed on a last-in-first-out basis (LIFO) instead of FIFO. Therefore, any taxable gain that comes out of the contract is reported before the nontaxable return of principal.
How do you reverse a MEC?
Yes there is a process to reverse MEC status if you discover you violated the 7-pay test. A lot of insurance companies make this process almost automatic in the sense that they will attempt to stop you from doing it before you technically achieve violation.
How are MEC policy loans taxed?
Generally, policy loans from non-MECs are not subject to income tax. But any withdrawals (including loans and partial or full surrenders) taken from the cash value of a MEC are treated as coming from earnings first and are taxed as ordinary income to the extent the policy”s cash value exceeds your basis.