To counteract what was perceived as abusive use of single-premium, limited-pay, and universal life policies as short-term, tax-sheltered cash accumulation or savings vehicle, 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).
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 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.
The basic rules are:
- Policies entered into before June 21, 1988, are grandfathered from the MEC rules unless the policies undergo a material change.
- 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.
- 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.
- 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.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM