Modified Endowment Contract
Candlefocus EditorThe seven pay test is a set of federal guidelines which outlines the total amount of money which can be contributed to a life insurance policy before it is deemed to be a Modified Endowment Contract. The rules are outlined in the Technical and Miscellaneous Revenue Act of 1988.
Under the seven pay test, a policyholder is only allowed seven years in which to pay the premiums required to cover the life insurance policy. Premiums exceeding these limits in any one year or total premiums that exceed seven times the first annual premium payment will trigger the MEC status. This is calculated over the duration of the policy, so it is possible to exceed the seven pay test with inflation adjusted payments, once the total of initial payments and all the following top ups reaches seven times the initial annual premium payment.
Once the Modified Endowment Contract status has been triggered, it cannot be reversed. This means that any withdrawals and earnings are taxed in the same way as withdrawals from an annuity that is not qualified. This tax treatment can be especially disadvantageous to the policy holder since it increases the taxable income, reducing the amount of funds available for distribution from the policy.
Modified Endowment Contracts are not necessarily a bad thing and can be beneficial for someone who wants to extract more money from their life insurance policy than the policy’s surrender value. An MEC enabled the policyholder to surpass this surrender value without breaching the regulatory limits. For some policyholders, this may be the most favorable solution, and the extra tax burden is worth the benefit of receiving the additional funds.
In conclusion, understanding the implications of Modified Endowment Contracts is important for policyholders so they can make an informed decision when financially planning with their life insurance policy. They should always pay careful attention to the seven pay test so that they do not unwittingly trigger the MEC status and be subjected to the increased tax weightings.