What is a 'modified endowment contract' (MEC)?

A modified endowment contract (MEC) is defined as a life insurance policy that has premium payments exceeding certain limits set by the IRS, which alters its tax treatment. Specifically, if the policy accumulates cash value and the total premiums paid within the first seven years exceed the IRS limits, it is classified as a MEC. This classification leads to more unfavorable tax implications, such as disadvantages in borrowing against the policy or cash value withdrawals, which may result in taxable income.

This concept is crucial for policyholders to understand as it affects how they can manage their life insurance policy in terms of accessing its cash value and the associated tax liabilities. The MEC status was established to prevent individuals from using life insurance primarily as a tax shelter, which is why it has specific criteria based on the premium payments made.