In the 1980s a lot of people, including physicians, were using life insurance policies as a tax shelter. They'd dump a big chunk of money into a policy, then borrow it back tax-free to use for other purposes. Interest rates were quite high, and the upper marginal tax brackets were atmospheric, so it was working out pretty well for some people. Congress decided it wasn't fair for people to use a life insurance policy just as a tax shelter, especially since some of the resulting policies didn't even resemble a traditional life insurance policy, term or permanent. In 1988, they changed the rules to prevent this abuse. I suspect some people wanted to outlaw cash-value life insurance all together, but given the strength of the life insurance lobby, what they ended up with was the concept of a modified endowment contract (MEC.)
7 Warnings About Modified Endowment Contracts
#1 Unfavorable Tax Consequences
An MEC is a special class of life insurance product with unfavorable tax consequences. Normally, with a cash-value life insurance product, you can borrow the cash value tax-free (but not usually fee-free). Then when you die, the cash value is paid back with the proceeds from the life insurance benefit (so your heirs get less money than they would have if you didn't borrow from the policy.) With an MEC, you have to pay taxes (and a penalty if you withdraw the money before age 59 1/2) on the money you borrow. So who would want that? Well, if you know you're not going to borrow from the policy, and it is money that is really designed for your heirs, then it is no big deal. But that defeats a major purpose of people who buy these things.
Most people don't want an MEC, but they have to be careful, because a cash-value life insurance policy that WASN'T SUPPOSED to be an MEC, can become one. And once it is an MEC, there's no going back. How does it become one? In two ways- when it is overfunded, and when changes are made to the policy. It is quite possible for this to occur completely accidentally. You do get a little time to correct the error, but not much (generally 60 days from the end of the policy year.)
#2 The 7-Pay Test
The rule is basically this- you can't contribute more to a policy than you would on a 7 year pay whole life policy with the same death benefit (meaning a whole life policy you would completely pay for in 7 years.) So if the policy costs $10,000 a year for 7 years, and you contribute $10K to it in year one and $15K in year two (and don't correct it), your policy just became a MEC. The insurance company usually helps you to track this stuff, but they can screw up too. After year 7, you can put more money into the policy without having to worry about it becoming a MEC, UNLESS you make a material change to the policy. Basically, the government doesn't want you to have a policy with a death benefit of $10K that you are making $50K premium payments to every year. It wants you to buy life insurance for life insurance purposes, not investment purposes.
#3 Material Changes
Any material change to a policy restarts the 7-year pay rule, or, automatically reclassifies a policy as a MEC. Material changes include a change in death benefit, addition of a rider or a change in its amount, section 1035 exchange, a change in smoker status or reduction in rating.
#4 Single-Premium Policies
Single-premium life insurance policies are no longer allowed. These are all MECs. You can still do them, for instance in an irrevocable trust, but don't plan on ever borrowing the cash value. More commonly, people simple pay over 7 or more years, or until death.
#5 Universal Life Policies
Universal life insurance policies are the most flexible of the cash-value life insurance policies. There are all kinds of interesting tricks you can do with these, including changing the premiums and death benefits to suit your needs and wants. But it is precisely those changes that trigger the MEC rules. Most MEC reclassifications come with Universal Life Policies.
#6 Whole and Variable Life Policies
Although more unusual, these policies can also become MECs under certain circumstances. This guy's whole life policy became reclassified as a MEC after he began withdrawing money from it. Variable life policies can also become MECs if overfunded through “unnecessary premiums.”
#7 Banking On Yourself
Bank on yourself is a concept heavily promoted by life insurance salesmen where you overfund a whole life policy using paid up addition riders early on to fund it just up to the MEC line and then repeatedly borrow the cash value from your insurance policy and use it to buy cars, houses, vacations, real estate investments etc. The theory is that you'll pay less in fees to the insurance company than you will in interest to the bank, at least on an after-tax basis. I don't really think it is a great idea (I prefer to bank on myself using saved money and just cut out the whole insurance industry), but those who use insurance in this way need to be particularly careful about MECs. The closer you get to the MEC line, the more likely your policy will become an MEC. That would be a financial disaster for someone doing the Bank On Yourself thing. Less likely with a whole life policy, but still possible. I suspect many bank on yourself enthusiasts will be burned by this in the coming years. I wouldn't be surprised if it gets too popular to see IRS MEC rules become even more strict.
In conclusion, you'll probably never have to understand the term MEC. Keep your insurance and investing separate and it won't be an issue.