MEC Basics

Modified Endowment Contract (MEC) and Premium Limit Information Basics 

Select the question below for more information.

» Are there limits on how much premium I can contribute to my policy?
» Why are these premium limits important?
» What type of premium limit is used to determine if my policy qualifies as life insurance?
» What happens if I exceed my guideline premium limit?
» What happens to my guideline premium limit if I increase or decrease my face amount?
» How is premium measured against the guideline premium limit?
» When and how is the MEC limit calculated?
» How is premium measured against the MEC limit?
» What happens if I exceed my MEC limit?
» What happens to my MEC limit if I change my face amount?
» What premium limit appears on the LifeBenefits site?

Are there limits on how much premium I can contribute to my policy?

Yes. There are two limits that restrict the amount of premium you can pay. Both limits relate to life insurance provisions in the Internal Revenue Code (IRC).

  • One limit ensures that your certificate qualifies as life insurance.
  • A second limit determines whether your certificate is a modified endowment contract (MEC).

For the majority of people, the premiums you pay will not approach these limits. If you contribute substantial premium amounts to accumulate an account value, the limits may apply. We will regularly test your certificate to identify when you reach a limit.

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Why are these premium limits important?

Under current tax law, a certificate that satisfies the definition of life insurance qualifies for tax-deferred growth of the account value as well as tax-free payment of the death benefit. If a certificate does not qualify, you lose these tax advantages.

Generally, you can continue contributing premium into a contract that is a MEC and maintain its status as life insurance. A withdrawal or loan taken from the cash value of a MEC, however, will be treated as a taxable distribution of any gain that exists in the contract. A 10% penalty also may apply if you are under age 59 ½. Cash value in a MEC continues to accumulate tax free (subject to the withdrawal rules described above) and death benefits paid to the beneficiary are income tax free.

This is a general discussion of the relevant tax laws. It was not intended for nor can it be used by any taxpayer for the purpose of avoiding Federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to the specific fact pattern.

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What type of premium limit is used to determine if my policy qualifies as life insurance?

Section 7702 of the Internal Revenue Code describes the tests a contract must meet to qualify as life insurance (the Deficit Reduction Act of 1984 adopted this definition so these tests are often referred to as "DEFRA tests"). Under current tax law, a certificate that satisfies the definition of life insurance provides for tax-deferred growth of the cash value as well as tax-free payment of the death benefit. To satisfy this definition, a contract must meet one of two tests:

  • The Guideline Premium Test

    This test sets a limit on the amount of premium that can be paid into a certificate. This limit is called the guideline premium limit and is based on the insured person's age, face amount, nicotine status, and death benefit option.
  • The Cash Value Accumulation Test
    This test sets a limit on the account value in your certificate as a percentage of the face amount of insurance. Your account value is allowed to be a higher percentage of your face amount as you get older.

Your group policyholder will select one of these tests for your group policy.

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What happens if I exceed my guideline premium limit?

We will not allow you to fail the guideline premium test. If you pay a premium that exceeds your guideline premium limit, this premium is returned to you. You must then either stop paying premiums for a period of time or increase your amount of insurance to continue to pay premiums.

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What happens to my guideline premium limit if I increase or decrease my face amount?

When you increase your face amount, your guideline premium limit will increase and when you decrease your face amount your guideline premium limit will decrease. If the face amount decrease causes the guideline premium limit to decrease below the cumulative premiums paid (causing you to fail the guideline premium test), you will have to withdraw cash value before you can decrease your face amount.

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How is premium measured against the guideline premium limit?

Premium, for purposes of testing against the guideline premium limit is:

  • the sum of any 1035 exchange cash value, any loan balances assumed in a 1035 exchange and all premiums paid since the certificate's effective dateless
  • withdrawals and refunded premium.

Premium is measured from the effective date of your certificate.

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When and how is the MEC limit calculated?

The MEC limit is calculated at each "material change". A material change occurs at issue of the contract and when the amount of insurance is increased or a future benefit is added. The most common type of material change is an increase in the face amount of insurance.

The MEC limit is calculated using a formula that depends on your age, your face amount of insurance and the account value at the time of the calculation. Using certain actuarial assumptions, this formula calculates a premium that, if paid over seven years, would be expected to fund the future benefits of the contract until maturity.

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How is premium measured against the MEC limit?

Total premiums paid since the last material change date, less withdrawals taken from the account value since the last material change date, cannot exceed the cumulative MEC limit. Since the limit is cumulative, if you pay premium that is less than the annual MEC limit one year, you are allowed to pay premium that is higher than the annual MEC limit in a subsequent year, as long as the cumulative MEC limit is not exceeded.

For example, if the annual MEC limit is $2,000 and $1,000 of premium is paid in the first year, $3,000 can be paid in the second year because the cumulative limit of $4,000 has not been exceeded (cumulative limit in the second year equals 2 x $2,000).

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What happens if I exceed my MEC limit?

We will notify you if you have exceeded your MEC limit and give you the choice of having your excess premium refunded or allowing your certificate to become a MEC. We assume that you do not want your certificate to become a MEC and we will refund any premium paid in excess of the limit unless you direct otherwise.

Once your certificate becomes a MEC it will always have this status.

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What happens to my MEC limit if I change my face amount?

If your face amount is increased, a new MEC limit will be calculated on the effective date of this higher face amount. Premium will then be measured against this new limit starting from the date the higher face amount is effective.

If your face amount is reduced during the seven-year period following a material change, the lower face amount is used to recalculate the MEC limit retroactive to the date of the last material change.

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What premium limit appears on the LifeBenefits site?

It is either the MEC limit or the guideline premium limit whichever is less. Note that if your certificate is a MEC, you may be able to pay more than what appears on this screen.

 

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