If you contribute too much money to the account's cash value, the policy may be declared a modified endowment contract, or MEC. While your life insurance coverage will remain unchanged, early withdrawal may result in additional taxes and penalties. However, if you understand how and when MEC rules apply, you can avoid the designation.

What is a modified endowment contract?

A modified endowment contract is a life insurance policy that has exceeded the IRS contribution limits. If both of the following statements are true, the IRS will declare a life insurance policy to be a MEC:

1. The policy became effective on or after June 21, 1988.
2. The policy fails the "7-pay test."

The ‘7-pay test’ explained

The IRS employs the 7-pay test to determine whether a cash value life insurance policy has been overfunded. These policies usually have a yearly limit on how much you can deposit into the account. This limit is based on the number of premiums required to pay off the policy in the first seven years. To be fully paid up means that the coverage has been paid in full and that no additional premiums are required to keep the coverage active. Policyholders may pay more than the minimum premium because the extra money is deposited into the cash value account and may increase the investment. However, if you pay more than the annual limit at any point during the first seven years, the policy will fail the 7-pay test and may be designated a MEC.

For example, if your policy's annual premium limit is $1,000 and you pay $2,000 in the second year of ownership, a MEC conversion will occur.

The 7-pay test applies during the first seven years of a policy's existence. If you make significant changes to your coverage, the clock is reset for another seven years. A material change is defined as anything that modifies the coverage, such as increasing the death benefit or adding a life insurance rider.

How does MEC insurance work?

Life insurance and modified endowment contracts are very similar. Because the death benefit remains intact, your life insurance beneficiaries will continue to receive the payout if you die. And the cash value account continues to grow tax-free. When you withdraw funds from the account, however, you may be subject to more taxes and fees than if you had a life insurance policy.

This is because the IRS treats withdrawals from a MEC differently. When you withdraw funds from a life insurance policy, the "policy basis" is deducted first. The basis is the amount you've paid in premiums, and you can withdraw it tax-free. So, if you do not withdraw more than the basis, you will not be taxed. The gains are withdrawn first under a modified endowment contract, and they are taxed as ordinary income.

MEC withdrawals typically incur a 10% tax penalty if taken out before the age of 5912 years. The 10% applies only to the gains, but because the gains are withdrawn first, you will almost certainly pay the penalty.

Paid-up additions rider

When researching modified endowment contracts, you may come across the term "paid-up additions," or PUA. A PUA rider essentially allows you to add small amounts of dividend-funded permanent life insurance. Policyholders can use PUAs to increase the overall death benefit and cash value of their policy while maintaining the correct insurance-to-investment ratio and avoiding a MEC conversion.

Pros and cons of a modified endowment contract

If your policy is designated as a MEC, it does not always imply disaster. The MEC rules were put in place to prevent policyholders from using their life insurance policies as tax-free investment vehicles. If you don't intend to withdraw the money soon, you could heavily fund the account and use the tax-deferred growth for retirement or estate planning.

However, if you plan to withdraw or borrow from the cash value before retiring, you should avoid MEC status.

Before making any permanent investment decisions with your life insurance policy, consult with a fee-only financial advisor.

Life insurance policy vs. modified endowment contract