What defines a Modified Endowment Contract (MEC) in life insurance?

A Modified Endowment Contract (MEC) is defined specifically by its failure to meet the seven-pay test, which is a requirement established by the IRS to determine whether a life insurance policy has been overly funded with premiums. When a policy is classified as a MEC, it triggers unfavorable tax treatment regarding distributions made from the policy, such as withdrawals and loans.

In a typical scenario, life insurance policies allow for tax-free withdrawals up to the amount of premiums paid, but once a policy is deemed a MEC, any distribution is subject to taxation on the gains first, and possibly an additional penalty if the policyholder is under age 59½. This specific taxation structure is what differentiates a MEC from other types of life insurance policies, emphasizing the importance of the seven-pay test in maintaining favorable tax treatment.

In contrast, a policy with a high death benefit or limited options for policy loans does not inherently define it as a MEC without considering the funding limits and structure established by the IRS guidelines. Similarly, a life insurance policy that successfully meets the seven-pay test is specifically excluded from being classified as a MEC. Thus, the defining characteristic of a MEC is its failure of that test, which results in the specified negative tax implications.