History

Congress passed legislation modifying IRS Code 7702, which provides the tax law definition of life insurance. On June 21, 1988 Code section 7702A was created. It defines a new class of life insurance contacts called a MEC.

Seven-Pay Test

The seven-pay test is mandated by the federal government to determine whether a life insurance policy is a MEC. Before June 21,1988, a life insurance policy was often used for investment purposes by funding it with a large lump sum premium and minimizing the death benefit.

Tax Consequences

In a MEC policy, any withdrawals, loans or use of cash value as collateral is taxed as ordinary income using the last-in, first-out (LIFO) method. Any withdrawals made before age 59 1/2 are also subject to a 10 percent penalty.

Benefit

One benefit of a MEC contract is the ability to transfer a large cash benefit to beneficiaries by using a one-time large premium and minimum death benefit to maximize cash growth. The cash, investment growth and death benefit are transferred to the beneficiaries tax free.

Avoiding MEC Policy

Insurance companies inform insurance policy owners of the seven-pay premium limits for the policy being purchased and track insurance premium payments.

Source:

USAA: What is a Modified Endowment Contract?

Cornell University Law School: U.S. Code Collection: § 7702A. Modified endowment contract defined

Trustmakers: Modified Endowment Contract