What is a 'Modified Endowment Contract' (MEC)?

A Modified Endowment Contract (MEC) is a life insurance policy that has been funded with more premium dollars than IRS rules allow under the '7-pay test'. The 7-pay test compares actual cumulative premiums in the first 7 years to the cumulative premiums that would have paid up the policy in 7 level annual payments. If actual premiums exceed the limit, the policy becomes a MEC. Tax consequences of MEC status: (1) withdrawals and loans are taxed on a 'gain first' basis (income tax applies to gains before basis is returned); (2) a 10% penalty applies to taxable distributions before age 59½; (3) death benefits remain income tax-free. Once a MEC, always a MEC. The MEC rules were enacted to prevent using life insurance primarily as a tax-deferred investment vehicle.