What is a Modified Endowment Contract, and what does it have to do with life insurance?

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If you're using Infinite Banking as a savings tool, you want to avoid having your policy become a MEC. But what exactly are Modified Endowment Contracts? How does it change the taxation on your life insurance policy? Why does it exist? And when might you want to use a MEC? 

If you want to know more about how to use Infinite Banking to accomplish your financial goals… tune in now!

Table of contentsDefining the Modified Endowment ContractHow MECs WorkThe Tax Consequences of a MECThe 7-Pay TestIs There An Upside to Having a MEC?Book A Strategy Call

Defining the Modified Endowment Contract

There are a lot of great reasons to have a whole life insurance policy. This includes tax advantages, uninterrupted compounding growth, and income protection. It’s the ideal vehicle for an infinite banking strategy–however, you can lose these benefits if you over-fund your policy. 

When you put too much money into a whole life insurance policy, it becomes something called a Modified Endowment Contract. When a policy becomes a MEC, it loses its tax advantages. The IRS created this legislation to cut down on what they deemed taking advantage of life insurance.

The original purpose of life insurance's tax advantages was to incentivize people to buy insurance. That’s because life insurance can protect families financially from a loss of income during a difficult time. This also prevents the government from having to commit tax dollars toward supporting these families. The government first implemented these benefits with a specific purpose in mind: to be a win for families. They didn't create the advantages as a loophole.

In order to protect the original intent of life insurance—to provide a death benefit—the IRS decided that if policyholders didn’t follow certain guidelines, it would functionally be classified as an investment, rather than an insurance policy. 

How MECs Work

Let’s consider an example. Say you want to buy a life insurance policy with a $1 million death benefit. The least you can pay, or the “floor," is going to be term insurance. This is the cheapest premium you can have, however, you only have the temporary death benefit and nothing more. 

What you can pay on a million-dollar policy, however, is a sliding scale. You can have different life insurance products or structures that change the premium. For example, you can have whole life insurance, structured in a few different ways. Typically, the higher your premium, the more benefits you get, including living benefits like a cash value account. 

A whole life insurance policy structured for infinite banking is at the top of this scale. Largely because of all the living benefits. Tax favorable growth, uninterrupted compounding interest, tax-free access via policy loans—these are just a few benefits, on top of your permanent insurance. 

The MEC rule creates an official “cap” to the sliding scale, preventing people from paying beyond the maximum, as they were prior to the late 80s. Now, if you go through the pay ceiling, you still have life insurance, but it will no longer have the same tax treatment.

The Tax Consequences of a MEC

With a MEC, your death benefit still passes to your heirs tax free, however, your living benefits no longer receive the same tax advantages. If you take a policy loan with a MEC contract, you will have to pay income taxes on that money. Additionally, if you withdraw money from your cash value before age 59 ½ you will be subject to penalties. 

A MEC policy gets similar treatment as a 401(k) or an IRA. If you are choosing to use whole life insurance primarily as a savings tool, or as an infinite banking policy, it’s important that you don’t MEC your policy. 

The 7-Pay Test

In order to determine what policies are a MEC, the IRS uses something called the 7-pay test.