What is a Modified Endowment Contract (MEC)?

A Modified Endowment Contract (MEC) is specifically a designation given to certain cash value life insurance contracts that have failed the IRS seven-pay test. This designation occurs when the premiums paid into the policy exceed certain limits in the first seven years of the contract. When a policy is classified as a MEC, it has unique tax implications, particularly regarding withdrawals and loans taken against the cash value.

One significant feature of a MEC is that any distributions, such as loans or withdrawals, are taxed as income, and if the policyholder is under age 59½, there may be an additional penalty because MECs do not enjoy the same tax advantages as traditional life insurance policies. This is crucial for policyholders or potential investors to understand as it affects how they can utilize their cash value without incurring unfavorable tax consequences.

In contrast, health insurance plans, tax-free savings accounts, and investment accounts do not align with the definition or characteristics of a MEC.