What is a Modified Endowment Contract?

The simple answer is this happens when a life insurance policy becomes “paid up” within seven years. We’ll dive deeper into this throughout the blog.

During your journey of researching the IBC I’m sure you have come across the term Modified Endowment Contract, or MEC for short. There is a lot of information out there saying that MECs are the worst things possible or that MECs are sometimes good.

Before we dive into that argument though, when did MEC’s come on the scene?

The Modified Endowment Contract was created in 1988 by the passing of the TAMRA Act.

A new tax law was passed in 1986 during the Reagan Administration. This new tax law increased corporate taxes, increased capital gains taxes, and added numerous other taxes to the tax code. The law eliminated many tax shelters wealthy people used, which sent them searching for new options. These people went to their tax advisors in hopes of finding the best shelter for their money. Most were surprised when they were advised to put large sums of their wealth in a single premium whole life insurance contract! (Isn’t whole life insurance the absolute worst place to put your money?)

Soon, many saw that the tax treatment and control of their own capital which was offered to them in a whole life insurance contract was second to none. The IRS didn’t like the wealthy using this as a new shelter for taxes, and therefore passed the TAMRA Act. This Act declared these single premium policies as Modified Endowment Contracts (you can have a MEC with products that aren’t single premium too). Those who purchased single premium polices before the law took effect were grandfathered in.

Modified Endowment Contracts are not treated as life insurance contracts by the IRS.

The treatment of a MEC is very similar to how qualified plans are treated.

Distributions with non-MEC policies are treated on a first in first out (FIFO) basis. This means that you can withdraw your cost basis (basis is your contributions to the policy) that you have paid in over the years tax free (it’s tax free because you already paid tax on the contributions), before taking out any gains.

MEC policy distributions are treated on a last in first out (LIFO) basis. This means that the policy holder must withdraw the taxable gain before they can withdraw the un-taxable basis. Whenever policy loans are taken, the amount of gains in the policy will be taxed as ordinary income as well. For example, you have paid $100,000 into a single premium policy ($100,000 is your cost basis). The policy cash value is now $115,000. You decide to take a policy loan for $20,000. Since your policy has $15,000 in gains, you will pay ordinary income tax on $15,000 of the $20,000 loan you took. Your cost basis is now $115,000.

Finally, withdrawals and loans are also subject to a 10% penalty tax for policy owners who are under the age of 59.5. This could be avoided if you’re using a 72 (v) distribution.

After reading this you probably think you should never buy a MEC policy.

For the IBC we do not design MECs, but there are some cases where a MEC can make sense.

We have created a MEC for a customer in their 70’s who was looking to take some of their money out of the stock market and lock in their gains. With this client our goal was to pass on as much income tax-free death benefit to his wife and children as possible. He didn’t need the money and the MEC gave him the most death benefit possible with making only one payment. The client can still access the money in case of emergency (or any reason really), and would just have to pay ordinary income tax on the gains in the policy.

How do you prevent a MEC?

According to Carlos Lara of the Nelson Nash Institute, “In order for any life insurance policy to avoid being classified as a MEC, there must be a difference in dollar value between the death benefit and the cash value of the policy. What is being eliminated or discouraged are premium payments that would make the cash value of the policy higher at any point in the first seven years, compared to a hypothetical policy of comparable death benefit that would be fully paid-up after seven equal premium payments.”

In English, this just means policies have a “7 Pay test”, and if we pay more into the policy than this allows, we’ve created a MEC. Once a policy has been classified as a MEC, it will forever be a MEC.

Here is a short example:

We’ll pretend I have just designed a policy with a MEC limit of $10,000. The 7 pay test says in the first 7 years you can pay in $70,000. You could do this as $10,000 per year. You could also do it as $8,000 the first year and $12,000 the second year. What you cannot do is pay $12,000 the first year and then $8,000 the second year (you can do this; it just creates a MEC).

If you’re still following here, you cannot ever get ahead of what $10,000 multiplied by the year you are in of your policy is cumulatively with premium. That is why the final example produced a MEC, in year 1 we had paid in more than $10,000 x 1 = $10,000. The second example was not a MEC because $10,000 x 2 = $20,000.  The first year we paid in $8,000 and the second year $12,000, so cumulatively we hadn’t crossed the 7 pay test.

How did Nelson Nash design policies?

When designing policies specifically for the IBC we like to snug up to, but not cross the MEC line as Nelson Nash would say. The illustration below comes directly out of Nelson’s book, Becoming Your Own Banker. It shows that when designing policies for the IBC we want to be right next to the MEC line (the arrow).

No such policy exists, so we get there by blending the ordinary life policy with the single premium policy, which is in the form of Paid Up Additions (PUAs). This gives us an efficient policy without the penalties and taxes of a traditional MEC.

Work with someone affiliated with the Nelson Nash Institute to help develop your plan.

The illustration above shows where these particular policies fall in proximity to being a MEC without any form of blending. The MEC line is to the left of the triangle or arrow and doesn’t have a policy listed at the top of it (it’s labeled modified endowment contract below instead). The closer you get to this line designing your policy, the more ideal it is for the IBC (this is why Nelson put the arrow close to the line).

Armed with this new knowledge about MEC’s, I hope you’re one step closer to getting started with your very own customized IBC plan.

If you need any help or additional knowledge around this or any subject regarding IBC you can get on our calendar here.