All About The MEC

All About The MEC

MEC Limit: The MEC Limit is the maximum amount of money you may deposit to a policy per year. This is an IRS limit. If we exceed this limit, our policy becomes classified as a MEC, and we have to deal with taxes. Did you know that you can set the MEC limit wherever you want? Below are a few bullet points that you may find helpful:

– The MEC Limit directly relates to your Age, Death Benefit, Gender, and Guaranteed Rate on a policy.

– Another name for the MEC Limit is the “7-Pay Premium test”. This has to do with the first seven years of a life insurance policy. If you have a $10,000 MEC limit policy, the maximum amount you can pay each year is $10,000 for the first seven years. Beginning year 8, the MEC limit will reset. The limit resets based on your age, death benefit, and cash value at the time.

– If you don’t use it, you don’t lose it. Any unused MEC space will roll over year-to-year. For example, if you have a $10,000 MEC Limit, you can pay $10,000 per year. If you pay $5,000 in year 1, you can pay $15,000 in year 2 to make up for the $5,000 you did not pay in the first year. Unused MEC space will continue to roll over as the years pass.

– What if you exceed your MEC limit? Not to worry. If you exceed your MEC limit, it is straightforward to reverse. Insurance companies will notify us, and we quickly reverse it.

A MEC, or Modified Endowment Contract, is a policy in which the premiums paid have exceeded the amount allowed to keep the full tax treatment of a cash value life insurance policy. Distributions of cash value are taken from taxable gains first, as compared to distributions taken from non-taxable contribution. In other words, withdrawals will typically be taxed as ordinary income (typically the highest rates for investments), instead of treated as non-taxable income.

Modified endowments were created in the Technical Corrections Act of 1988 in response to single-premium life (endowments) being used as tax shelters. This established the 7-Pay Test, which is a stipulated premium that would create a guaranteed paid-up policy within 7 years from policy inception. If premiums paid to the contract go beyond the premium amount stipulated, then the contract has failed the 7-Pay Test and is reclassified as a Modified Endowment Contract.

Distributions will switch from a First-In, First-Out (FIFO) basis to a Last-In, First-Out (LIFO) basis. For example, if you contribute $100,000 into a policy and have $150,000 in cash value, you will be taxed on the $50,000 gain first.

Policy loans will be realized as ordinary income to the policy owner and could be subject to income taxes in the year the loan is made. Distributions (either withdrawals or loans) that go beyond the policy basis will be subject to a 10% penalty tax for policy owners under the age of 59-1/2.

Transferring funds from a Modified Endowment Contract to a new life insurance policy via the 1035 exchange privilege will render the newly issued contract as a Modified Endowment Contract as well.