A MEC, or Modified Endowment Contract, is a policy in which the premiums paid have exceeded the amount allowed to keep the full tax treatment of a cash value life insurance policy. Distributions of cash value are taken from taxable gains first, as compared to distributions taken from non-taxable contribution. In other words, withdrawals will typically be taxed as ordinary income (typically the highest rates for investments), instead of treated as non-taxable income.
History of the MEC:
Modified endowments were created in the Technical Corrections Act of 1988 in response to single-premium life (endowments) being used as tax shelters. This established the 7-Pay Test, which is a stipulated premium that would create a guaranteed paid-up policy within 7 years from policy inception. If premiums paid to the contract go beyond the premium amount stipulated, then the contract has failed the 7-Pay Test and is reclassified as a Modified Endowment Contract.
Distributions will switch from a First-In, First-Out (FIFO) basis to a Last-In, First-Out (LIFO) basis. For example, if you contribute $100,000 into a policy and have $150,000 in cash value, you will be taxed on the $50,000 gain first.
Policy loans will be realized as ordinary income to the policy owner and could be subject to income taxes in the year the loan is made. Distributions (either withdrawals or loans) that go beyond the policy basis will be subject to a 10% penalty tax for policy owners under the age of 59-1/2.
Transferring funds from a Modified Endowment Contract to a new life insurance policy via the 1035 exchange privilege will render the newly issued contract as a Modified Endowment Contract as well.