Which type of insurance policy is at risk of being classified as a Modified Endowment Contract?

A Modified Endowment Contract (MEC) is a designation that applies to certain life insurance policies that fail to meet specific IRS guidelines regarding premium contributions. This classification is important because MECs have different tax implications, particularly regarding tax-free withdrawals and loans against the policy.

Universal life insurance is a flexible premium permanent life insurance product that can be structured in such a way that it becomes a Modified Endowment Contract if the premium payments exceed certain limits set forth by the IRS. The flexibility of premium payments allows policyholders to pay large amounts upfront, which can lead to the policy being classified as a MEC if it violates the seven-pay test—a measure of whether the total premiums paid exceed the premium limit for the first seven years of the contract.

On the other hand, term life insurance does not accumulate cash value and is therefore not at risk of becoming a MEC. Whole life insurance typically adheres to predetermined premium structures that help it avoid MEC status when properly designed. Variable life insurance also has the potential to be classified as a MEC, but its structure allows policyholders to choose how their cash value is invested, which can complicate its classification; however, universal life insurance, due to its flexible premium nature, is a more common example in discussions about MECs.