A) What is a MEC?
B) How does a contract become a MEC?
C) What exactly are the consequences of a MEC?
A) A Modified Endowment Contract is what occurs when a Life Insurance Policy fails a test that differentiates between a policy purchased for Death Benefit versus a policy purchased for Tax Advantages.
B) Determining if a contract is a MEC is based on the annual premium required to pay-up the policy in seven years. This limit is generally referred to as the seven-pay limit. Life Insurance Policies violate the seven-year limit any time the cumulative amount paid in the first seven years exceeds the cumulative MEC limit applicable in that policy year.
Once out of the first seven years policies can still be classified as MECs if there is a material change to the contract. Face amount increases increase/addition of riders, plan changes, or even exchanges of the insured can cause a policy to be “Retested”.
Another way for a policy to become a MEC is to reduce the Death Benefit in the first seven years where the premiums paid in would have caused a MEC had the policy been issued at the reduced Death Benefit amount. Reductions include: face amount reductions, partial surrenders, cancellations or reductions of qualified additional benefit rider, or a lapse that is reinstated after 90 days.
It is important to note that qualifying 1035 exchanges do not affect the MEC status of a policy.
C) The consequences of a MEC depend on how the policy is used. If your policy becomes a MEC but no distributions are taken during the insured’s lifetime then there will be no adverse tax implications on the Death Benefit.
However, should distributions be taken during the lifetime of the insured, distributions will be taxed as “income first” and not “basis first” the way non-MEC distributions are viewed. Taxable distributions would include: policy loans (including automatic premium loans), collateral assignments, cash dividends, dividends applied for any purpose other than to reduce the premium on the same contract, full and partial surrenders, and account withdrawals.
In addition, there may be an additional 10% tax. Exceptions for the additional tax are made for any insured that has become disabled and/or is over age 59 1/2.
If a corporation owns the policy, there are no exemptions.