Modified endowment contract (MEC)

MEC is a US federal income tax status. It decides how a US taxpayer is taxed on money taken from an IUL policy or a PPLI structure during the insured's lifetime.

How the seven-pay test works

A contract entered into on or after 21 June 1988 that meets the US definition of life insurance (section 7702) is a MEC if it fails the seven-pay test or was received in exchange for a MEC (section 7702A).

• The test. In the first seven contract years, total premiums paid must never exceed the sum of the seven-pay premiums to date: the level annual premium that would pay the policy up in seven years.
• Lower cover. If benefits are cut within the first seven years, the policy is retested as if issued at the lower level.
• Material changes. A material change, such as a higher death benefit after issue, starts a fresh seven-year test.

MEC and non-MEC compared

• Withdrawals. Non-MEC: taxed only once they exceed the investment in the contract, broadly the premiums paid. In the first 15 contract years, a withdrawal that comes with a cut in the death benefit can be taxed income first, up to a recapture limit (section 7702(f)(7)). MEC: taxed income first, up to the gain: the cash value before surrender charges, less the investment in the contract.
• Loans and pledges. Non-MEC: a policy loan is not a distribution. MEC: a policy loan, or a pledge of the policy as security for a Lombard loan, is a distribution.
• 10% additional tax. MEC only, on the taxable part, unless the taxpayer is 59½ or older, is disabled, or takes substantially equal periodic payments for life or life expectancy.
• Growth and death benefit. A MEC still meets section 7702, so the build-up is not taxed each year, and the death benefit stays excluded from gross income under section 101(a), subject to exceptions such as a transfer for value.

Worked example

Illustrative figures, not a forecast. A US taxpayer aged 45 pays US$1,000,000 into a policy with a seven-pay premium of US$150,000. In year 10, aged 55, they take US$200,000 from a cash value of US$1,600,000.

• As a MEC. One premium, above the year-one limit. The US$600,000 gain comes out first, so all US$200,000 is taxable, plus a 10% additional tax of US$20,000.
• As a non-MEC. US$125,000 a year for eight years, inside the limit every year. A US$200,000 loan is not a distribution. A US$200,000 withdrawal comes out of the US$1,000,000 investment first and is not taxed when taken, unless it cuts the death benefit, when part can be taxed income first under the section 7702(f)(7) recapture rule.

In an international IUL

MEC status has no effect on an international IUL held by someone with no US tax ties; international IUL is issued to non-US persons. Where a US taxpayer holds IUL, a single premium usually makes a MEC, which suits money with no lifetime access. A non-MEC, with premiums spread on a limited-pay basis and set within the seven-pay limit, suits planned loans or withdrawals.

In a PPLI structure

PPLI structures are available to US taxpayers, and the same test applies. A structure funded with one large premium is usually a MEC: while it meets section 7702 and the US diversification and investor control rules, the portfolio compounds with no annual US income tax charge, and the death benefit keeps its section 101(a) treatment. A structure built for lifetime liquidity is a non-MEC, with premiums spread to pass the seven-pay test and access through loans from the insurer.

Common questions

Is a MEC a bad thing?

No. For a US taxpayer it is a design choice that suits money meant to pass on death.

Can a MEC become a non-MEC again?

Generally no. A policy that fails the seven-pay test stays a MEC for that year and every year after. The exceptions sit with the insurer: excess premium refunded with interest within 60 days after the contract year ends does not count, and the IRS can agree to treat an inadvertent MEC as a non-MEC under Rev. Proc. 2008-39.

Sources

• 26 U.S.C. § 7702A: modified endowment contract defined
• 26 U.S.C. § 72(e) and (v): distributions, loans, MECs and the 10% additional tax
• 26 U.S.C. § 101(a): death benefit excluded from gross income
• 26 U.S.C. § 7702: life insurance contract defined, including the 7702(f)(7) recapture rule
• IRS Rev. Proc. 2008-39: tax treatment of amounts received under a MEC

Last reviewed November 2026.