What is a Modified Endowment Contract (MEC)?

When premiums are paid into a life insurance policy more quickly than normal (usually less than 7 years), the policy is still a life insurance policy but it is considered a Modified Endowment Contract, or MEC.

How does a life insurance policy become a MEC?

Under the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), the federal government limits the amount of money that can be paid into a life insurance policy within the first 7 years from the date of issue. This is referred to as the 7 Pay Test. If the amount paid within the first 7 years exceeds the limit, the policy will be classified as a MEC.

Are Single Premium policies considered MEC’s?

Yes. TAMRA makes any net single premium life insurance policy, such as AAFMAA’s Wealth Builder Life Insurance policy, a MEC.

Gains are taxed first for any withdrawals, either by loan or cash surrender, under last in first out (LIFO) accounting. The cost basis is not taxed however it will be considered the last money to come out of the MEC for tax purposes. The gain is taxed as ordinary income to the owner.

Are there additional penalties for withdrawals?

Yes. Any withdrawals before age 59 ½ is subject to a 10% penalty on the amount of any gain.

Is the Death Benefit taxed?

The death benefit of a MEC can still be passed to beneficiary’s tax free.

Can a MEC be reclassified as a life insurance policy?

Once a life insurance policy is classified as a MEC, it cannot be changed back to a non-MEC policy.

Are there any implications if I have multiple MEC policies as opposed to a single, larger policy?

The IRS considers Wealth Builder Life Insurance or any other MEC policy, issued by the same insurer to the same policyholder during the same calendar year, to be aggregated when determining the amount of any distribution that is taxable.

What are the potential tax implications of having multiple MEC policies?

If you decide to cash surrender one of several policies purchased during the same calendar year, you will have to pay taxes on the interest earned for all of the policies with that first policy. When you cash surrender subsequent policies, since you have already paid some or all of the taxes, you will pay less tax on the gain for those subsequent policies. Ultimately the amount of total taxes if the polices are surrendered will be the same, because the tax basis of the subsequent policies will be increased to reflect the taxes already paid. There will be no impact on policies that are annuitized, if all polices surrendered simultaneously, or if the policy owners dies.

Does a MEC policy, such as Wealth Builder Life Insurance make sense?

YES - Although these policies have a slightly reduced tax benefit if they are cashed in separately, they still serve as a stable retirement planning tool. They are good alternatives to annuities, which immediately become taxable upon the death of the owner. All AAFMAA life insurance benefits pass tax-free to heirs. Wealth Builder Life Insurance can be appropriate for members who do not qualify for other insurance products, for members looking for a way to leave a tax-free inheritance to family members, or for members who wish to annuitize their policies and receive a steady stream of income for the remainder of their life.

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Financial Planning, Investment Management, and Trust Services provided by AAFMAA Wealth Management & Trust, a North Carolina Limited Liability Company wholly owned by AAFMAA. Physical address: 639 Executive Place, Suite 200, Fayetteville, NC 28305.
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