Modified Endowment Contract

CFA Book 2, p. 241 “The policy will be considered a modified endowment contract if the accumulated premiums paid at any time during the first seven years after the policy is established exceed the sum of the net level premiums that would have been paid on or before such time if the future benefits provided in respect of the policy were deemed to be paid up after the payment of seven annual premiums.” Can someone try explain this paragraph in plain language, especially the deal with seven year rule? My understanding of the difference between modified endowment contract (MEC) and non-modified endowment contract (Non-MEC) in the context of variable life insurance policy is that if you fund the policy with large lump sum in proportion to your future death benefit it becomes MEC but if you fund it gradualy in 4-5 years (not sure what the deal with 7 years and if funding supposed to be gradual but below 7 years?) then it becomes Non-MEC and you can take advantage of tax-free loans against your policy that are available under Non-MEC. this wiki entry was helpful, however it still has similarly confusing paragraph as CFA book


The MEC rules were put in place to make sure one of the tax benefit from insurance (tax free access to the build up cash value inside the policy) were not abused by insurance companies which had policies with only a tiny bit of life insurance and tons of premium and cash value. They figured people were really using these as cash accumulation devices, like annuities, rather than for their death benefit feature, which is what the tax benefit were meant for. The 7 pay rule was instituted so that you could not pay so much premium that the policy would be paid off in seven years. That means if you have a policy which only requires 7 years of premiums, and the policy death benefit is locked in and never requires another premium, then the MEC rule kicks in and you lose the benefit of income tax free acess to cash value growth. Do not get this confused with policies where the internal dividend or borrowings from the cash value pays for the premium. The 7 pay rule is arbitrary, why not 6 or 8, but where the compromise was reached where the insurance policy loses the ability to access the tax free buildup. The impact of the MEC rule is to make all withdrawals (loans) of the cash value - taxable income rather than being able to use the loans are not income rule. There is no change to the cash value growth and death benefit being income tax free rule, only on the withdrawals from the MEC policy. Hope this helps.

Thanks, that clarifies it. A couple more questions. 1) Does it make a difference of how do you fund the policy in the first 7 years for it to be considered a MEC, assuming that these payment(s) will lock the death benefit it (i.e. if you fund it with 1 lump sum payment or 7 gradual payment)? If I understood you correctly then it doesn’t make a difference, if the death benefit is locked in within first 7 year years it becomes a MEC. 2) Assuming I have hypothetical policy with death benefit of $701K, if I make 7 annual payments of $100K then it can qualify as non-MEC, since $1 will be left unpaid or does the 7 year rule also consider growth on the money I contributed (i.e. interest earned on my $700K will surely exceed $1 and that will lock in the death benefit even though the real contributions were below the full death benefit amount). 3) Wikipedia says “the death benefit is paid income tax free if premiums are paid with after tax money”. I suppose its safe to assume that if I able to fund the policy with before tax dollars similarly to an IRA (not sure if its even possible) then the original principal will be taxed to beneficiaries as income.

You are thinking about it rightly, but bear in mind that what Congress was trying to achieve with the MEC rule was to make certain that in the first 7 years of a policy that a certain “corridor” existed between Death Benefit and cash value. If that corridor is violated (ie too much cash relative to Death Benefit) then the policy becomes a MEC. Incidentally being a MEC isn’t the end of the world, as the Death Benefits are still income tax free, however you lose the ability to access cash values via a policy loan as a tax free loan. To you question on purchasing Life Insurance using IRA assets, this is a prohibited transaction, but it can be done in certain cases in 401(k)/Profit Sharing Plans. But here, tread cautiously and with a good guide. Hope that helps a little.

Thanks, that certainly helps.

The only people who truly understand the intricacies of this rule are actuaries, so I wouldn’t go crazy in trying to understand how it works exactly. GL