What is a Modified Endowment Contract (MEC)?

A Modified Endowment Contract (MEC) refers specifically to a life insurance policy that fails to meet the criteria of the 7-Pay Test, which is a measure of how much can be paid into a life insurance policy in the first seven years without it being deemed an MEC. The 7-Pay Test stipulates that the cumulative premiums paid during the first seven years cannot exceed the sum of the seven annual premiums based on the policy's death benefit. When a policy becomes an MEC, it shifts the tax treatment of the cash value. Distributions from an MEC are subject to income taxation and potentially a penalty if taken before the insured reaches age 59½.

Understanding this definition is crucial for recognizing the implications of MECs, including how they impact a policyholder's tax situation and investment strategy. Other options illustrate different aspects of life insurance but do not define a MEC accurately, making it clear that the core distinction lies in the failure to adhere to the 7-Pay Test.