Modified Endowment Contracts: Setting Up a Personal Pot of Gold

by FIG Marketing
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Updated September 6, 2023, at 9:51 PM

Finding the right financial solution for clients can be difficult, especially when we’re talking about emergency savings.

On the one hand, they need some liquidity. On the other hand, you hope they never need it. You want it to be safe, but you’d also like to see it grow.

There are many factors to consider when deciding where to stash a client’s rainy-day fund, but a modified endowment contract (MEC) life insurance policy may just be your lucky charm.

What is a Modified Endowment Contract Anyway?

Many people aren’t familiar with MECs because they weren’t designed as a “product,” strictly speaking. A MEC describes a life insurance policy that’s exceeded federal tax law limits and no longer qualifies for some of the tax advantages the IRS provides for non-MEC life insurance policies. An even shorter description: a MEC is an over-funded life insurance policy.

Why Does the IRS Make This Distinction?

Permanent life insurance policies have a lot of benefits and tax advantages. One advantage is that a client can withdraw funds or borrow against their policy income-tax-free. Should they die before funds are replaced or the loan is repaid, and the balance would be subtracted from the death benefit before it passes to their beneficiary.

The IRS allows you to withdraw or borrow against the accumulated cash value, which consists of the premiums clients have paid and the interest they’ve earned along the way. If a policy is overfunded too much, the IRS recognizes that it may be getting overfunded intentionally to create this opportunity, which means the policy is seen as an investment vehicle rather than as traditional life insurance.

This is often referred to as the seven-pay limit (or MEC test limit), contained in Revenue Code Section 7702A. The IRS makes this distinction because the primary purpose of life insurance is to provide a safety net for families in the event their income-earner(s) pass away.

These products are particularly useful for families that haven’t accumulated a great deal of wealth or savings, as they may still be in the early stages of their career. If something were to happen to their income during this stage, they may not have a financial cushion that could sustain their lifestyle.

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Life insurance allows these families to use their current income to secure an influx of cash in the event their income earner(s) can no longer provide for them. When a life insurance policy doesn’t pass the MEC test, it’s clear that the policy isn’t serving its intended purpose, and therefore loses its First-in-First-out (FIFO) tax benefit.

Note: A MEC status doesn’t affect the income-tax-free status of the death benefit; it only affects the funds that a policy owner might choose to access during their lifetime.


One rule of thumb to understand the difference between a non-MEC life insurance policy and a MEC life insurance policy is to look at FIFO versus Last-in-First-out (LIFO).

Non-MEC Life Insurance FIFO

The first funds put into the policy are the first to be taken or borrowed against. FIFO means borrowing against the principal first (rather than the interest earned in the policy).

By avoiding the interest earned, there’s no worry about paying income tax on the funds that are withdrawn or borrowed. This is a very desirable benefit, especially for someone in a high tax bracket.

MEC Life Insurance LIFO

The last funds put into the policy are the first to be taken or borrowed against. LIFO means borrowing against the accumulated interest first (rather than the principal). Therefore, the gains are subject to income tax, and clients will owe those taxes in the event they withdraw or borrow against them.

If they’re under 59 1/2, any gains withdrawn would also be subject to a 10% early withdrawal penalty.

Note: Both MECs and non-MECs may be subject to surrender charges depending on the carrier and product selected.

A Modified Endowment Contract Can Happen on Purpose or on Accident

A policy owner may unintentionally overpay their life insurance premiums and exceed the MEC test limit. When this happens, the life insurance carrier has a 60-day window to refund the overpayment to avoid a MEC status, allowing the policy owner to maintain their tax-advantaged withdrawal and loan capabilities.

Note: Once a policy enters MEC status and passes the 60-day window, the MEC status can’t be reversed.

Conversely, a policy owner may elect to put their life insurance policy into a MEC status from day one, especially if they have a lump-sum to deposit. When selecting a MEC, a policy owner may also opt for a lower death benefit to decrease the cost of insurance charges, which will build up their cash value more efficiently.

Using a MEC this way allows the policy owner to benefit from a life insurance policy’s many advantages while their lump-sum savings grow tax-deferred. This can be particularly appealing to an investor who doesn’t want—or expect to need—access to the cash value in their policy during their lifetime.

Note: A MEC policy owner still has access to their cash value; the only caveat is they’d need to pay income taxes on the gains from their withdrawal, along with a 10% penalty if they’re under age 59 1/2.

What are the Shared Advantages of a Non-MEC and a MEC Life Insurance Policy?

1. Protection from market risk.

Safe financial solutions are essential in developing a diversified plan and protecting nest eggs from a volatile market. Life insurance products can offer market downside protection, while certain types of policies provide an opportunity to participate in upside market potential.

2. Tax-free death benefit.

Many beneficiaries aren’t prepared for the tax burden that accompanies their inheritance. The ability to set up a tax-free death benefit for heirs is an important consideration in estate planning. Life insurance policies and MECs expand the ability to plan for your client’s future and family.

3. Tax-deferred growth of cash value.

The ability to grow a lump-sum savings tax-deferred will allow compounded interest to grow much more efficiently in the long term. Many solutions that offer the benefit of tax-deferral are limited to retirement accounts, such as traditional and Roth IRAs, which have strict contribution limits.

MEC and non-MEC life insurance can offer a tax-efficient alternative without contribution limits. This can be a useful retirement planning solution, especially for those who’ve maxed out their retirement contributions.

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4. Creditor protection features.

Along with its many tax benefits, life insurance and MECs can have significant creditor protection features so that in the event a client was sued, their policy may be treated differently from other assets. The extent of this protection will vary largely from state to state.

5. Tax-advantaged rider benefits.

In general, benefits from riders enjoy the same tax advantages as the policy itself.

What Makes Modified Endowment Contracts Special?

When you consider using a MEC as a stowaway for emergency funds and excess savings, there are unique advantages that you’d be hard-pressed to find in an alternative financial instrument.

Savings Account

Interest-bearing savings accounts aren’t what they used to be. Many pay a fraction of a percent, while high-yield savings (HYS) rates still hover around 1% and may lock money up for months, forfeiting interest in the event clients need their money sooner.

While savings and HYS accounts will provide FDIC insurance and protection against market risk, they’ll expose clients to inflation and opportunity risk, with virtually no upside potential. There are also very few circumstances in which these products can offer any tax advantages or protection from creditors.

A savings account may be a great option to retain three to six months of living expenses in case of an emergency, but as they continue to accumulate wealth, it’s advisable to explore more lucrative options for their nest egg.

Money Market Account

Not to be confused with money market funds, money market accounts (MMAs) are bank products (similar to savings or HYS accounts), that offer more competitive interest rates but may place limits on transactions. MMAs offer similar pros and cons to savings and HYS accounts, with rates under 1% in the current low-interest landscape.

Certificates of Deposit

Certificates of deposit (CDs) are a bank product that’ll pay a higher interest rate in exchange for agreeing to leave the money alone for an extended period, known as the term of the CD. The term can range from one month to a few years, and typically, longer terms offer higher rates. Again, these products share many of the benefits and downsides of HYS and MMA accounts in that they’re generally safe with little upside potential (especially in a low-interest environment). Current one-year CD rates are under 1%.

While a CD might be a great option to park funds for a set amount of time—say, while saving for a down payment on a home—their limited upside potential and lack of tax advantages make them a less-than-powerful tool for retirement preparation, tax optimization, or estate planning.

Money Market Fund

Unlike an MMA, a money market fund isn’t a bank product but a type of mutual fund that holds low-risk investments and generates income. While these funds are generally considered safe and liquid, they’re not recommended to meet long-term investment goals, nor do they offer extensive tax advantages beyond some of their holdings, which may include government-issued bonds.


Annuities certainly have their share of advantages and will often prove an
excellent alternative for many individuals looking to make the most of their savings. Since annuities are designed to provide a lifetime stream of income after they’re annuitized, their protection against longevity risk is unrivaled.

Both solutions boast a wide range of products that offer downside protection and the ability to select contracts that provide an opportunity to participate in upside potential. They’re also similar from a liquidity standpoint since both have surrender charges and any withdrawals or loans are subject to LIFO treatment.

However, from an estate planning perspective, a MEC provides the ability to leave heirs a tax-free inheritance, which isn’t a feature available with annuities.


Like a MEC, bonds can offer reliable protection from market downside and are comparatively illiquid since bondholders are beholden to their maturity dates—often longer than one year—before they can recollect their principal.

Some bonds do offer tax advantages, such as government-issued bonds whose gains may be exempt from federal or municipal taxes. However, from an estate planning perspective, leaving these gains to heirs without additional measures could result in a large tax burden for the beneficiaries.

Similar to annuities, bonds offer the opportunity to collect income, but they’ll expose bondholders to interest rate risk. As we’ve seen over the past ten years, historically low interest rates have made bonds a less lucrative option than they once were.

Parting Words on Modified Endowment Contracts

There’s no shortage of low-risk options for your client’s pot of gold, but finding the right one for their phase of life, risk aversion, time horizon, and need for liquidity can be a challenge. The MEC is an often-overlooked solution that offers a unique combination of advantages with a wide variety of options to suit their specific needs and objectives.

The ability to create a MEC from their policy is just one more way that you can tailor these solutions to meet clients’ specific needs.

Keep Reading: A Black Cloud Over Life Insurance Settlements [Case Study]

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The content within this document is for informational and educational purposes only and does not constitute legal, tax or investment advice. Customers should consult a legal or tax professional regarding their own situation. This document is not an offer to purchase, sell, replace, or exchange any product. Insurance company products and any related features, benefits and/or guarantees are backed by the claims paying ability of the issuing insurance company. Insurance policy applications are vetted through an underwriting process set forth by the issuing insurance company. Some applications may not be accepted based upon adverse underwriting results. Some types of permanent insurance may require consistent premium payments, or the policy may risk lapsing. Unpaid policy loans decrease future death benefits paid to beneficiaries. Excessive policy loans may cause the need for future premium payments. If an insurance policy lapses due to excessive policy loans or if a customer surrenders their policy, one may be subject to tax payments for any policy loans that exceeds the premiums paid. Excessive premium payments may cause the policy to become a modified endowment contract. Policies classified as modified endowment contracts may be subject to taxes when a loan or withdrawal is made.

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