Understanding the definition of a MEC in a Life Insurance Contract

Hello producers,

Prior to selling a life insurnace contract, all insurance agents should understand the definition of a MEC. I will be giving more detailed information in the near future.

Modified endowment contract: The MEC came into being with the 1988 amendment to the tax code (TAMRA, IRC Sec. 72 and Sec. 7702A). People were putting large sums of money into policies to accumulate funds on a tax-deferred basis. TAMRA provided that if a policy was over-funded (whether at issue or at a later date), it would be classified as a MEC, and any distribution representing a gain from the policy would be taxed.
The seven-pay test establishes limits to the amount of premiums that can be paid within a seven-year period. “Material changes” that occur to an in-force policy can cause a policy to be retested as if the changes existed since the beginning of the policy.
If a policy is or becomes a MEC, distributions will be taxed on a last-in first-out, or LIFO, basis to the extent of gain, subject to a 10 percent penalty, unless the distribution is made after age 59½, or if death, disability or annuitization occurs. Distributions include policy loans, cash dividends, withdrawals and surrenders.
If a policy becomes a MEC, it is “tainted” for as long as it exists and carries over to any policy that is issued in exchange for a MEC. A Sec. 1035 exchange is a material change for MEC purposes and is retested. Cash values that are transferred from the existing policy will not count as premium. If the policy fails the material change test, it will be classified as a MEC.
Sec. 1035 policy exchanges: When a policyowner exchanges an existing life insurance policy in accordance with IRC Sec. 1035, no gain is attributed on the exchange. The adjusted basis of the old policy is carried over to the new one. Only the newly added premium will be measured for MEC status. A Sec. 1035 exchange is allowed only when transferring cash values from an annuity to an annuity, life insurance to life insurance, or life insurance to an annuity contract.