Modified Endowment Contract (MEC)

Withdrawals and loans are taxed on a LIFO basis, gain first, with a 10% penalty on distributions before age 59 and a half — A modified endowment contract (MEC) is created when a life insurance policy is funded faster than the seven-pay test permits. Because the contract is overfunded as an investment, withdrawals and loans are taxed on a last-in, first-out (LIFO) basis, meaning taxable gain is distributed first, and distributions before age 59 and a half are subject to a 10% penalty. The death benefit, however, remains income-tax-free to the beneficiary under IRC Section 101(a), and the contract continues to operate as life insurance.

National insurance concept

The death benefit remains generally income tax free, but withdrawals and loans are taxed on a gain-first basis and may be subject to a 10% penalty before age 59 1/2 — A policy becomes a modified endowment contract when premiums exceed the 7-pay limit under IRC Section 7702. The death benefit remains generally income tax free under IRC Section 101(a). However, distributions and loans from a MEC are taxed on a LIFO basis, meaning the gain is taxed first, and a 10% additional tax applies to taxable amounts taken before age 59 1/2, subject to certain exceptions. MEC status therefore removes the favorable loan and withdrawal treatment of a life policy while preserving the tax-free death benefit. Agents should warn clients that funding a policy too heavily can create MEC status.

National insurance concept