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Life Insurance

Modified Endowment Contracts: How They Work and Why They Matter

What is a Modified Endowment Contract (MEC)? 

A Modified Endowment Contract (MEC) is a type of life insurance policy that has been funded with more money than allowed under federal tax law, causing it to lose some of the tax advantages typically associated with life insurance.

Permanent life insurance plans include a cash surrender value feature that builds with each premium and earns guaranteed interest. However, because this cash value grows tax-deferred, the IRS limits how quickly you can channel funds into your policy. If you overfund your policy beyond the IRS threshold, your insurer will convert it to a modified endowment contract (MEC), carrying more restrictive tax rules and penalties for accessing its cash value.

By laying down this MEC tripwire, the government redesignated life insurance as more of a tool for estate planning and retirement income instead of a personal tax shelter. Luckily, MEC status should prove relatively avoidable for adequately structured and supervised insurance policies.

When Saving For The Future Can Cost You More 

Before modified endowment contracts existed, people could invest large sums of cash in their permanent life insurance accounts to exploit the inherent tax-free distributions and tax-deferred earnings growth. The IRS effectively ended this loophole by passing the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which introduced MECs and the tests used to designate them. All cash value life insurance, including universal, whole, and variable policies, must now undergo annual TAMRA testing. Policies that fail these tests by outpacing their funding limits risk becoming MECs.

While MECs still allow tax-deferred cash accumulation and a tax-free death benefit, all cash value distributions will undergo taxation equivalent to their account’s growth. Additionally, these distributions promote only retirement-oriented money movement by levying a 10% early withdrawal penalty before age 59.5. This occurs on any access of the cash value, even when accessed as a policy loan.

In short, attempting to overfund your permanent life insurance policy to maximize your savings potential may cost you much more by invoking MEC status.

How Does a Modified Endowment Contract Work? 

When you pay premiums on whole life insurance, a percentage of each payment goes toward your policy’s cash surrender value. You can typically withdraw from or borrow against this cash value throughout your life without taxation. However, suppose you overfund your cash value beyond IRS limits and trigger MEC designation. In that case, you lose your ability to freely move money from your account without paying taxes or incurring secondary penalties.

Federal funding limits vary depending on your death benefit threshold, which in turn gets decided by numerous factors, including your age, gender, and overall health. Even if you exceed funding limits and lose your tax benefits to MEC status, you still retain this tax-free death benefit, payable toward your beneficiaries.

How a Cash Value Life Insurance Policy Becomes a Modified Endowment Contract

According to the IRS standards, your cash value life insurance policy will become a modified endowment contract if it meets all of the following criteria:

  1. You opened your policy after TAMRA legislation passed.
  2. You exceed your funding limits to the point that you fail your “seven-pay test.”
  3. You ignore overfunding warnings from your insurance provider and decline to refund your account to below MEC limits.

7 Pay Test 

Once per year, during the first seven years of your life insurance policy, the government will conduct tests to monitor funding activity. To pass these “seven-pay tests,” the cumulative premiums paid toward your policy value cannot exceed the cumulative MEC limit of each test year. Though cash value life insurance policies are often financially structured over several years, this threshold equates to the cost of a policy hypothetically paid up within exactly seven years. Regardless of the size of the previous or following years’ contributions, breaching your seven-pay threshold will activate MEC designation.

Your insurer will warn you before you breach MEC territory and allow you to return excess funds to retain conventional life insurance status. Refer to the two charts below. Even though they ultimately end on the same final payment amount, the second policy exceeds its cumulative limit in year 5, permanently taking on MEC status.

Passing Policy

YearAnnual PremiumMEC Status

Failed Policy

YearAnnual PremiumMEC Status

Tax Implication Comparison 

Recently converted MECs still offer the same features of the permanent life insurance policies preceding them, albeit with more significant tax implications:

TaxesWhole LifeMEC
Growth of Interest and DividendsTax-freeTax-deferred
Growth of Cash ValueCan be used tax-free through policy loansTaxed when used
Policy LoansTax-freeTaxed
Retirement IncomeTax-freeTaxed
Income Death BenefitTax-freeTax-free
Estate Death BenefitTax-freeTax-free

As you can see, MECs still allow you to take out policy loans, grow cash value, grow interest and dividends, and draw from your cash value. However, any time you choose to move or access these funds, they will get taxed. Your death benefit, on the contrary, remains intact and untaxable in both MECs and whole life insurance.

First-in-first-out (FIFO) vs. Last-in-first-out (LIFO) Taxation 

Whole life insurance policies and MECs most prominently differ in how they account for withdrawals. Whole life insurance policies observe a first-in-first-out (FIFO) system, meaning that every policy loan or withdrawal from your account’s cash value comes from the earliest premiums paid on the policy. Once you exhaust those premiums, the leftover interest and dividends get taxed like regular income. For example, a $5,000 withdrawal from an account with $4,000 in premiums and $1,000 in gains would only get taxed on the $1,000.

Alternatively, MECs utilize a last-in-first-out (LIFO) methodology, drawing from and immediately taxing the most recent funds for each distribution or loan. Suppose your MEC had a $20,000 cash value, $16,000 of which in premiums and $4,000 in interest. A $10,000 withdrawal would include all $4,000 in taxable interest and the remaining $6,000 from your premiums. An equivalent $10,000 FIFO withdrawal from an identical life insurance account would only draw from your premiums, bypassing taxation.

Most insurance companies offer supplemental products called policy riders, some of which may allow you to increase the overall benefits of your life insurance plan.

Paid-up additions are essentially tiny single premium life insurance policies that are bought with policy dividends from participating whole life contracts. Single premium life insurance policies when purchased alone, are immediately a MEC. But these paid-up additions, because they are smaller and structured into a larger policy, essentially boost the policy’s cash value growth effectiveness.

Common Uses for a Modified Endowment Contract 

TAMRA took away the tax advantages of overfunding life insurance policies to encourage people to utilize them as estate and retirement planning tools. MECs promote similar usage by retaining their original policies’ tax-free death benefit and tax-differed cash accumulation.

Estate Planning 

MECs still deliver a lump sum tax-free death benefit to your family after you die, making them an excellent foundation for estate planning. Furthermore, the cash value of MEC death benefits typically earn higher interest rates than similar investment methods like CDs or money market accounts.

MECs only make sense as estate planning tools for people with enough money to survive their remaining years without accessing their cash surrender value. As long as you fully intend to use an MEC to leave money behind for your beneficiaries, taxable distributions, and penalties don’t apply to your situation.

Retirement Planning 

MECs are considered single-premium life insurance policies because the funds get added in one lump sum or a series of large payments, allowing cash to accrue rapidly. Further, they fail the 7 pay test in the first year.

Even though distributed funds become taxable as income, you could still use them to help carry you through retirement. This alternative retirement plan would not make as much sense for individuals under 59½, as they would incur additional penalties for each withdrawal.

Speak to a financial advisor to see if your MEC could function as a proper retirement strategy. Generally speaking, most people looking to replace income later in life prove better off investing in more conventional accounts like a 401(k) or permanent life insurance retirement plan (LIRP).

Advantages of a Modified Endowment Contract 

Even though TAMRA ended the exploitation of whole life insurance policies by implementing LIFO and withdrawal penalties, policies converted to MECs still offer some advantages to their clientele.

Death Benefit Tax Exemption 

MECs still deliver your death benefit to your beneficiaries completely tax-free. Therefore, you can intentionally overfund your account to guarantee your family’s security, given you have enough cash to see you through retirement. Just don’t change your mind later and start withdrawing funds for personal use, as this would undermine the sole tax-free benefit MECs provide.


Patrons can easily access funds in their MEC accounts when necessary, as these endowments allow greater liquidity than money invested in other areas like real estate or stocks. As long as policyholders understand the extra taxes and penalties involved, MEC money movement could offer some use as an emergency account during retirement. 

Holder for Large Sums of Money 

While MECs lose many of the benefits offered by whole life insurance policies, they still function as a safe storage place for large sums of money. In this regard, you might think of an MEC similarly to purchasing a savings bond or investing in a college fund for your next of kin. Separating your finances based on their intended purposes ensures safe storage and delivery for your beneficiaries.

Disadvantages of a Modified Endowment Contract 

While MECs offer limited advantages, they present numerous drawbacks that should deter most policyholders from overfunding their seven pay threshold.

Policy Loans Treated as Income 

Traditionally, the IRS will not tax loans against an active life insurance account’s cash value. Once your plan transfers to an MEC, funds withdrawn from growth in your account become subject to tax as ordinary income, meaning you’ll owe taxes regardless of when or how you pull from accrued interest on your cash surrender value.

Loss of FIFO 

Arguably, the most significant consequence of a life insurance policy taking on MEC status comes from losing first-in-first-out taxation. FIFO allows members to defer paying taxes on cash value growth until they access more than the premiums they have paid into their policy. Once your policy becomes an MEC, LIFO practices permanently apply, requiring taxes upfront with each withdrawal of interest and dividends.

Tax Penalties on Withdrawals Before 59 1/2 

People under 59½ cannot withdraw from their MEC without incurring an additional 10% penalty. Once you age beyond 59½, these penalties no longer apply, but you will still owe LIFO taxes. Essentially, no one can withdraw from a MEC without incurring some form of taxation, penalty, or both.

How to Avoid a Modified Endowment Contract 

To prevent your cash value policy from turning into an MEC, adhere to the following guidelines:

  • Be Mindful of Premiums:  If life insurance premium payments exceed their MEC limit at any point during the first seven years, you trigger MEC designation. For example, if your MEC limit is $1,000 annually, and you pay $1,500 in year four of your policy, it will permanently shift to an MEC.
  • Select a Non-MEC Policy: Plans without a cash value feature, such as term life insurance policies, do not risk MEC classification.
  • Consider Paid-up Policies: Paid-up additions riders (PUAs) structured into whole life insurance policies give customers more flexibility to maximize cash value before triggering MEC designation.
  • Understand Tax Implications:  Failing to understand your deferred and exempted tax benefits and the consequences of abusing them, intentionally or accidentally, could lead you to stumble into MEC territory.
  • Avoid Overfunding Your Policy Beyond the Seven-Pay Threshold:  Though your insurance provider will give you fair warning, failing the seven-pay test risks MEC designation.   

Consider Multiple Insurance Policies 

As of 2023, the IRS does not regulate how many life insurance policies a person can have. If your insurance company allows multiple plans, you can contribute large sums to the cash value of two or more policies. However, only some insurers will allow this, and no provider will ever insure your life for more than its worth.  

Reversing a Modified Endowment Contract 

You cannot reverse an MEC once your policy officially changes over, though you will have opportunities to walk back activity to avoid this policy conversion. The insurance agent monitoring your account will know your MEC limits and warn you should you edge close to the line or overfund your account. Before alerting the IRS, your insurance provider will allow you to refund an overpayment to keep your original status.

You can also authorize your insurer to process the payment and notify the IRS of the MEC violation, meaning you ultimately decide whether or not you lose your life insurance to an MEC. Just remember that once you let this happen, you can never change it back.

Final Thoughts 

Determine your financial goals and intentions behind whole life insurance before deciding on a plan. Once you secure a policy, check with your insurance carrier to confirm it will pass the annual seven-pay test. Doing so will avoid MEC designation and allow you to maximize your policy’s cash value benefits.

Modified endowment contracts resemble other retirement funds like IRAs or qualified annuity contracts more closely than whole life insurance. If your policy becomes an MEC, you can still deliver your family their inheritance through a tax-free death benefit. Therefore, MEC status may not affect people with enough capital to survive retirement without withdrawing from their endowment’s cash value.