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Generally speaking, an endowment policy is an investment instrument. Endowment life insurance policies promise to pay the face amount if the insured survives until the end of a specified period (for example, 20 years, 30 years, or until the insured's age 65), and also if the insured dies within that same specified period. Endowments require premiums far in excess of the amount required to fund the death benefit alone.
Following the elimination of many traditional tax shelters by the Tax Reform Act of 1984, single premium life insurance remained one of the few financial products offering significant tax advantages. Consequently, many of these policies were purchased solely to set aside large sums of money for tax-deferred growth, as well as tax-free cash flow available through policy loans and partial surrenders.
To curtail this activity, and to determine whether an insurance policy is overfunded, the Internal Revenue Service (IRS) established what is known as the 7-pay test. Any life insurance policy that fails a 7-pay test is classified as a Modified Endowment Contract (MEC), and loses the standard tax benefits of a life insurance contract. In a MEC, the cumulative premiums paid during the first 7 years of the policy exceed the total amount of net level premiums that would be required to pay the policy up using guaranteed mortality costs and interest.
Once a policy fails the 7-pay test and becomes a MEC, it remains a MEC.
A MEC is an overfunded life insurance policy that failed the 7-pay test. Once a MEC, always a MEC!
All life insurance policies are subject to the 7-pay test, and any time there is a material change to a policy (such as an increase in the death benefit), a new 7-pay test is required. Whether from a life insurance policy or a MEC, the death benefit received by the beneficiary is tax free.
As defined by Section 7702A of the IRS Code, a Modified Endowment Contract (MEC) is a contract that meets the requirements of a life insurance contract, but fails to meet the 7-pay test, or that is received in exchange for a MEC.
The following taxation rules apply to a MEC's cash value: