What is a MEC?
Know This:
MECs are not always bad. There are several strategies that allow the use of a MEC for the policyholder’s benefit. If you think that your contributions will exceed the limits of MEC – make sure to discuss your options with your trusted local agent.
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MEC Background:
When the Universal Life Policies were just getting started, insurance companies allowed consumers to purchase policies with very low Death Benefit, while giving the ability to greatly overfund the cash value portion of the account. The cash value was then invested in an annuity.
What this means is that it was an insurance policy in the name only. The real purpose was to use it as an investment account, which gets the tax-benefits of life insurance. As a result, Life Insurance was used more like a Tax Shelter for the wealthy, instead of an Insurance Policy.
So, in the 1980’s Congress established the Modified Endowment Contract (MEC) qualification and the rules about what is considered a real (Bona-Fide) insurance and what is not. This way, MECs get taxed differently from Universal or Whole life policies.
7-Pay Test:
Insurance policies become MECs when the premiums paid to the policy EXCEED what was needed to be paid within that seven-year time frame. This number is based ONLY on the pure insurance costs and does not include any administrative expense.
The qualifications for a MEC are:
- The policy is written on or after June 20, 1988.
- Policy MEETS the statutory definition of a life insurance policy.
- The policy FAILS to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.
While MEC still provides Tax-Deferred growth and pays out the Death Benefit (life insurance) to the beneficiaries Tax-Free, any distributions to the policy owner (prior to death) are taxable as income and additional tax is owed on distribution prior to attaining the age of 59.5 years old.
Key Point: You can’t accidentally turn into a MEC.
Insurers are verifying the account for a possibility of a MEC during the receipt of EACH premium – to see if the client paid in too much. If a violation is noticed, the client is immediately notified and MUST make a choice – to go the MEC route or to receive the refund of the “violating” sum.
If the policy holder violated the 7 Pay rule, MEC can be prevented by requesting the refund of the “violating” sum (if it was not sent back automatically by the insurer). Policy holder has up to 60 days after the close of the policy year, in which the violation took place.
Whenever the policy undergoes Material Change, it may also turn into a MEC, if the underlying calculations have changed. Material Change can trigger the MEC even after the 7-year rule.