A Modified Endowment Contract (MEC) is a special type of cash value life insurance policy that requires extra attention because of the tax laws associated with it. The federal tax law definition of “life insurance” limits your ability to pay certain high levels of premiums. Potentially, any insurance policy that accumulates cash value can be classified as a MEC, either when the policy is issued, or in later years.

1. A Guide to
Understanding
Modified Endowment Contracts
(MEC)
PLC.6177 (02.12)

2. A Guide to Understanding
Modified Endowment Contracts
What is a Modified Endowment Contract (MEC)?
A Modified Endowment Contract (MEC) is a special type of cash value life insurance
policy that requires extra attention because of the tax laws associated with it. The
federal tax law definition of “life insurance” limits your ability to pay certain high levels
of premiums. Potentially, any insurance policy that accumulates cash value can be
classified as a MEC, either when the policy is issued, or in later years. The policy will be
classified as a MEC if your premiums violate the “7-pay test” or “MEC test” (described
in the comments below). The 7-pay test must be applied for any cash value policy
when it is issued, and then continuously during the first seven years. It will also need to
be applied in later years if any “material change” in the policy occurs (discussed below).
How do you know if your life insurance policy is a MEC?
To determine if a contract is a MEC, the tax law places a limit on the amount of cumu-
lative premiums that can be paid into any cash value policy during the first seven years
from either the date the policy was issued, or seven years after any “material change”
in the policy. For more information about the MEC limit, talk to your agent.
The MEC rules apply to contracts issued on or after June 21, 1988. Life insurance
contracts issued before that date are considered grandfathered and are not subject to
the MEC test as long as certain policy changes are not made to these contracts that
would cause them to lose their “grandfathered” status.
Example of a 7-pay Limit or MEC Limit
Here’s an example of how your policy can achieve MEC status:
• ou purchase a $100,000 flexible premium universal life insurance policy.
Y
• The maximum MEC limit for the policy is $3,000 each year for the first seven years of the policy.
This means that if you pay $3,000 or less in premium annually for the first seven years, and your
policy will not be classified as a MEC.
• Year 1: In the first year, you pay the maximum amount of $3,000.
• Year 2: In the second year, due to an unexpected expense, you decide to pay only $2,000.
• Year 3: Since the MEC test is a “cumulative premium” test, in the third year you could pay
$4,000 and remain under the cumulative MEC limit of $9,000 ($3,000 annually x 3 = $9,000
cumulative MEC limit).
• Year 4: If you submit a $4,000 payment in the fourth year, the total premium payments over
the four years would equal $13,000, and would exceed the cumulative MEC premium limit.
($3,000 x 4 = cumulative MEC premium limit of $12,000) The additional $1,000 you applied
your policy in the fourth year would make your policy classified as a MEC.
Protective Life will notify you if we receive a payment that will cause you to exceed
a MEC limit, so you can make an informed decision if you want your policy status
changed to become a MEC. Protective Life will require a signed acknowledgement form
be completed to verify that you understand your decision to accept a MEC status and
the impact it will have should you decide to take any future distributions from the policy.

3. Material Changes
Material changes to life insurance policies include: a face amount increase or
decrease; the cancellation or reduction of a benefit rider or an increase in its benefit
amount; a reduction in substandard rating; a change to non-smoker status; partial
cash surrender or a substitution of insured. Any and all of these changes would
trigger a MEC re-test that could result in a loss of a Non-MEC status. Protective Life
will inform you if a requested policy change will cause your policy to lose its Non-MEC
status, so that you can make the most appropriate decision based upon your
circumstances. Should you decide to proceed with the policy change that will cause a
MEC status, Protective Life will require a signed and dated acknowledgement form to
confirm your understanding of the tax implications pertaining to any future distributions
from the policy.
Is it a bad thing to have your life insurance policy classified as a MEC?
While there are some adverse consequences when a policy is classified as a MEC,
there are also some positives. If your policy is a MEC, it is still considered a life
insurance policy and will still provide tax-free death benefits and tax-deferred cash
value accumulation.
Once a policy is classified as a MEC, its MEC status is irrevocable. Even if the MEC
policy is replaced with a new policy via a 1035 tax-deferred exchange, the new policy
will also be classified as a MEC. There are no exceptions to this result.
If the purpose of the insurance policy was for death benefit coverage only, then a MEC
status should not be a negative consideration. If your intent is to access policy values
in the future, for example to supplement your retirement years, then a MEC status
should be avoided if the tax costs outweigh the policy benefits.
The Negative Tax Implications of a MEC
If your policy is a MEC, any pre-death distributions are taxed as “income first” (not
basis first), meaning they are taxable to the extent of gain in the policy. This is known
as the “last-in-first-out” (LIFO) accounting method. With LIFO, income is taxed first
(before recovery of cost basis)—like an annuity. In contrast, non-MEC policies enjoy
the more favorable “first-in-first-out” (FIFO) accounting method (withdrawals are tax
free up to basis, and then you can switch to policy loans to continue distributions on a
tax-advantaged basis). If a distribution is made from a MEC before you are age 59 ½,
assuming you are the policy owner, the distribution will also be subject to a 10%
additional tax. There is an exception if you, the policy owner, are age 59 ½ or older or
have become disabled. This exception does not apply if a policy is owned by a
non-natural entity such as a business or Irrevocable Life Insurance Trust (ILIT).
Examples of MEC taxable distributions:
Partial or full cash surrenders, policy loans (including automatic premium loans for
whole life insurance MEC contracts), cash dividends, or dividends applied for any
purpose other than to reduce the premium on the same contract are examples of
MEC taxable distributions.

4. What are taxable events for MECs?
• If you make an assignment of rights or benefits under a MEC life insurance policy, you may
be deemed to have received a distribution and the policy will lose its tax-deferred cash value
accumulation benefit, thereby subjecting any annual interest income to taxes.
• If your policy is a MEC, any distribution from your policy will be taxed on an “income-first” basis.
Distributions for this purpose include a loan (including any increase in the loan amount to pay
interest on an existing loan or an assignment or a pledge to secure a loan) or withdrawal.
• Under a MEC status, an additional 10% penalty tax will apply to the taxable portion of any
distributions from the policy before age 59 ½. If the policy owner is a non-natural entity such as
a corporation or life insurance trust, all distributions throughout the lifetime of the policy, will be
subject to the additional 10% penalty tax.
• All amounts includible in income under a life insurance policy will be considered ordinary
income as opposed to capital gain.
If you have questions about MECs or your life insurance policy, you should contact your Protective Life representative. You may also
contact Protective Life’s Customer Service Department at 1-800-866-9933. A Protective Life customer service representative can
assist you in providing information about specific transactions relating to the MEC status of your policy.
Neither Protective Life nor its representatives offer legal or tax advice. The information contained in this brochure
represents our current understanding of the tax law in general and is not to be considered legal or tax advice by
purchasers. The tax treatment of life insurance is subject to change at any time. Purchasers should consult with their
legal or tax adviser regarding their individual situations before making any tax related decisions.
PLC.6177 (02.12)