Modified Endowment Contract
Also called MEC, modified endowment
A life policy funded so fast it fails an IRS test and loses its tax advantages — withdrawals and loans become taxable, with a penalty before age 59½.
A Modified Endowment Contract is a life insurance policy that was funded too quickly and, as a result, lost its favorable tax treatment. Congress created the category in 1988 to stop people from using life insurance as a disguised tax shelter — stuffing cash in, letting it grow tax-deferred, then borrowing it out tax-free. The gatekeeper is the 7-pay test: it caps how much premium you can pay in the policy’s first seven years relative to a level-pay policy of the same death benefit. Cross that cumulative limit and the contract is a MEC.
Becoming a MEC doesn’t kill the policy, but it changes the tax rules on the cash value in ways that matter. Policy loans and withdrawals — normally a tax-advantaged way to access cash value — are taxed gains-first (LIFO), and any amount taken before age 59½ carries a 10% penalty on top. The death benefit generally stays income-tax-free, but the living tax benefits, the whole reason many people overfund a policy, are gone.
The irony is that MEC status usually results from doing exactly what an aggressive agent suggested. Strategies like infinite banking and “max-funded IUL” work by pushing as much money into the policy as possible — which is precisely what trips the 7-pay test if the design isn’t carefully throttled just under the limit. And a 1035 exchange into a new policy carries the MEC taint with it; you can’t wash it off.
If anyone pitches overfunding a policy for tax-free income, make them show you the math: “What’s the 7-pay MEC limit on this design, and how much headroom is left each year?” Staying under that line is the entire ballgame — and crossing it is permanent.
A MEC quietly strips the main tax benefit people buy permanent insurance for. Once a policy is a MEC it's permanent — you can't undo it — and loans or withdrawals you were told would be tax-free become taxable income.
Someone dumps $100,000 into a small whole life policy in year one to 'supercharge the cash value.' That overfunding blows past the 7-pay limit, so the policy becomes a MEC. Now every loan and withdrawal is taxed gains-first, and pulling money before 59½ adds a 10% penalty — the opposite of the tax-free income they were promised.
Any pitch to 'max-fund' a policy for tax-free retirement income. Ask the carrier for the MEC limit (the 7-pay premium) in writing and confirm the design stays under it. Crossing that line is easy to do and impossible to reverse.