Tax Treatment of Modified Endowment Contracts

To counteract what was perceived as an abusive use of single-premium, limited-pay, and universal life policies as short-term, tax-sheltered cash accumulation or savings vehicles, Congress passed legislation modifying Internal Revenue Code section 7702, which provides the tax law definition of a life insurance contract. Code section 7702A, which was drafted to correct the perceived abuses, defines a new class of insurance contracts called Modified Endowment Contracts (MEC).1

The basic difference between MECs and other life insurance contracts is the federal income tax treatment of amounts received during the insured’s life. Certain distributions under the contract—ones that are not generally subject to tax when received from other life insurance contracts—are subject to income tax and, in some cases, a 10 percent penalty when received from MECs.

In other respects, MECs are treated and taxed under the same rules applying to other life insurance contracts that are not MECs. Basically, compared with policies that are not classified as MECs, MECs have detrimental tax consequences for some living benefits, but the tax treatment of cash accumulations within the policy and death benefits is no different than other policies.

What is a MEC? A MEC is a policy that meets the section 7702A definition of life insurance and is funded more rapidly than a paid-up policy based on seven statutorily-defined level annual premiums. (See Chapter 21 for more information on section 7702A.)

The basic rules are:

  1. Policies entered into before June 21, 1988, are grandfathered from the MEC rules unless the policies undergo a material change.
  2. All policies entered into after June 20, 1988, and any policy, whenever issued, that undergoes a material change must be tested under the MEC classification rules.
  3. Once a policy is classified as a MEC, it remains a MEC. A MEC will not change its MEC status if it is changed, adjusted, or reconfigured as a policy that would otherwise not be classified as a MEC.
  4. A policy received in exchange for a MEC is also a MEC, even if the policy that is received would otherwise not be classified as a MEC.


The tax treatment of certain amounts received from MECs prior to death—called distributions under the contract—is generally the same as the tax treatment afforded to annuity distributions. To the extent of gain in the policy, distributions from a MEC are taxed on a LIFO (Last In, First Out) basis, so gain comes out first. In other words, unlike non-MEC policies which are taxed on a FIFO (First In, First Out) basis, the first distributions out of a MEC contract are not considered a tax-free return of the policyowner’s cost basis, but rather the investment earnings on the contract. Those earnings are deemed to be withdrawn, and therefore become taxable, before the policyowner can recover his or her tax-free basis. So, only after all income or gain in the policy has been received are additional amounts treated as nontaxable return of the policyowner’s cost basis or investment in the contract.

In addition to the tax on distributions under the contract, a second tax is imposed in certain cases. This second tax is a 10 percent penalty tax. It is imposed on amounts received that are included in gross income (i.e., the taxable gain that is distributed).2

This 10 percent penalty tax does not apply to any distribution:

  1. made on or after the taxpayer attains age 59½ years of age;
  2. attributable to the taxpayer becoming disabled; or
  3. that is part of a series of substantially equal periodic payments made for the life (or life expectancy) of the taxpayer or for the joint lives (or life expectancies) of the taxpayer and beneficiary.

Note that the exceptions to the 10 percent penalty tax focus on the taxpayer, rather than the insured. Where the taxpayer (generally the policyowner) is a non-natural person, such as a business or a nongrantor irrevocable trust, there may be no exceptions to the 10 percent penalty tax. This is due to the fact that a non-natural person doesn’t have an age, can’t become disabled, and doesn’t have a life or life expectancy over which substantially equal periodic payments can be made. Thus, making a life insurance contract a MEC when the owner will be a non-natural person should be avoided if there is any possibility that distributions may need to be taken from the policy during the life of the insured. However, if the non-natural owner is tax-exempt, the 10 percent penalty is likely not an issue.

Generally, gain in the contract is determined by subtracting adjusted premiums paid from policy cash values. Adjusted premiums are total premiums paid (excluding premiums paid for supplementary benefits such as waiver of premium and accidental death benefit features) less any dividends received in cash or credited against premiums and less the nontaxable portion of any previous withdrawals. Cash value is computed without regard to surrender charges and so, for this purpose, is really the policy’s reserve or account value. Therefore, gain may exist and result in taxation of a distribution even though a policyowner cannot actually access it. Also, in some cases, a full surrender could yield less tax than a partial withdrawal.

Amounts received that are treated as income-first distributions under the contract include:

  • policy loans (to pay premiums as well as for all other purposes);
  • loans secured by the contract (i.e., pledging the MEC policy as collateral);
  • interest accrued on a policy loan;
  • withdrawals;
  • cash dividends; and
  • dividends retained by the insurer as principal or interest on a policy loan.

Amounts received that are not treated as income-first distributions under the contract include:

  • dividends retained by the insurer to pay premiums or other consideration for the contract;
  • dividends used to purchase paid-up additions, term insurance, or other qualified additional benefits; and
  • surrender of paid-up additions to pay premiums. However, it should be noted that the status of surrendering paid-up additions to pay premiums is uncertain. Most commentators feel they are not income-first distributions under the contract, but the issue has not yet been completely settled.

Using a MEC contract as collateral is a tax trap that can also cause a taxable distribution of any gain in the contract to the extent of the collateral assignment. This is due to the fact that pledges or assignments of any portion of the contract are treated as distributions.6 Situations where this tax trap can arise include using a MEC contract in a split dollar, loan, or premium financing arrangement. Note that the absence of gain in the contract at the time of the collateral assignment doesn’t necessarily mean that there is no tax issue. Although there does not appear to be any IRS guidance, it is the authors’ opinion that once gain begins to accrue in the contract, if the assignment is still in place, then such gain may become taxable each year until the assignment is removed.

MEC tax treatment applies to amounts received during the contract year in which a policy effectively becomes a MEC as well as to amounts received in any subsequent contract year. It also applies to any distributions in the two years before the policy fails the seven-pay test.7

Example. Kathy purchased a life insurance contract on January 1, 2017. As of January 1, 2019, her basis in the policy is $100,000. The contract has a cash value of $140,000. The policy is a MEC. She borrows $50,000 from the policy’s cash value on her fiftieth birthday. Kathy’s taxable gain from the loan is $40,000 ($140,000 cash value—$100,000 basis in the policy). If Kathy is in the 25 percent income tax bracket, she must pay income tax of $10,000 and a 10 percent penalty on the taxable amount ($4,000), leaving her with a total tax bill of $14,000 from the policy loan. Note that all amounts included in Kathy’s gross income as a result of taking a loan from the policy will be added to her basis in the policy for purposes of determining future taxable amounts. Therefore, Kathy’s basis in the policy after taking the loan will be $140,000 ($100,000 original basis plus $40,000 taxable portion of loan). The $10,000 nontaxable portion does not affect Kathy’s basis in the contract because the transaction is a loan and not a withdrawal.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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