Modified endowment contract
A modified endowment contract (MEC) is a life insurance contract that uses last-in first-out accounting mirroring annuity taxation, with gains withdrawn first.
How it works
A MEC is taxed in the way an annuity is taxed. Gains are withdrawn first and taxed at ordinary rates, with penalties for early withdrawals if applicable.
The 7-pay test is the measure connected to MEC status. Paying premiums over a minimum number of years is the usual way a contract satisfies that test.
Where it shows up for owners of businesses, real estate and private investments
A single-premium life insurance contract is a modified endowment contract. Pledging an MEC as collateral for a loan is treated as a taxable distribution.
Points that are easy to confuse
The 7-pay test and the collateral treatment address different events. The test relates to the number of years over which premiums are paid, while the collateral treatment relates to a loan secured by the contract.
Last-in first-out ordering sets which dollars come out of an MEC first. A penalty for early withdrawals is a separate feature that applies if applicable.
Common questions
How are withdrawals from a modified endowment contract taxed?
Under that approach gains are withdrawn first and taxed at ordinary rates. Penalties for early withdrawals apply if applicable to the person taking the withdrawal.
What happens when an MEC is pledged as collateral for a loan?
Practitioners note that pledging an MEC as collateral for a loan is treated as a taxable distribution.