A modified endowment contract is a cash value life insurance contract in the United States where the premiums paid have exceeded the amount allowed to keep the full tax treatment of a cash value life insurance policy. In a modified endowment contract, distributions of cash value are taken from taxable gains first as compared to distributions taken from non taxable contributions. In other words, withdrawals will typically be taxed as ordinary income (typically the highest rates for investments) instead of treated as non taxable income.
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History
Modified endowments were created in the Technical Corrections Act of 1988 (H.R 4333, S. 2238) in response to single-premium life (endowments) being used as tax shelters. The Act of 1988 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 (i.e. are higher than) the premium amount stipulated then the contract has failed the 7-Pay Test and is reclassified as a Modified Endowment Contract.
Tax rules
Distributions will switch from a First In First Out (FIFO) basis to a Last In First Out (LIFO) basis. This means that withdrawals will require the policy owner to withdraw taxable gain before withdrawing untaxable basis.
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 59.5 (this can be avoided by the use of a 72(v) distribution)
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 Modified Endowment Contract as well.
Use
In some cases, such as for estate planning, a person may purposely create a modified endowment contract in order to purchase the least insurance and therefore have the lowest insurance costs possible in order to receive the desired benefit. It may be used to pass more money on to heirs.