What is a Modified Endowment Contract (MEC)?

A Modified Endowment Contract (MEC) is defined by its failure to meet the 7-pay test, which is a rule established by the Internal Revenue Service (IRS). When a life insurance policy becomes a MEC, it means that the policyholder has funded the policy with premiums that exceed the limit set by the 7-pay test over a seven-year period. Consequently, once a contract is classified as a MEC, it loses certain tax advantages that typically apply to life insurance policies.

One of the main implications of a policy being classified as a MEC is that any withdrawals or loans taken against the policy may incur immediate taxation on the gains, as well as potential penalties if the policyholder is under age 59½. This classification can significantly impact the overall financial strategy of an individual holding such a policy, as the favorable tax treatment associated with life insurance is diminished.

The other choices do not accurately capture the essence of what a Modified Endowment Contract represents. A life insurance policy that passes the 7-pay test would still retain its favorable tax status. A regular life insurance policy may or may not be a MEC depending on its funding relative to the 7-pay rule, and a type of short-term investment plan does not relate to life insurance policies at