Glossary
Modified endowment contract, defined
A life policy that has been funded faster than federal tax rules allow, so it loses the favourable tax treatment of withdrawals and loans while keeping the tax-free death benefit. The test compares cumulative premiums against a limit set for the policy's face amount over its first seven years.
In practice
The status is permanent once triggered and cannot be undone by taking money back out. Loans and withdrawals from such a policy are taxed as income to the extent of gain first, and a further penalty tax applies to withdrawals before the age the tax code sets, which is the reverse of the ordinary rule. Carriers monitor the limit and usually warn before a payment would cross it, and a rider to buy paid-up additions is typically capped for the same reason. A material change to the policy, such as a face amount increase, restarts the test. Some buyers accept the status deliberately for a single-premium policy meant only for a death benefit; that is a decision to make on purpose, not by accident.
A worked example
Suppose the seven-pay limit on a $200,000 whole life policy is $8,000 a year and the owner pays $10,000 in year two. The policy becomes a modified endowment. Suppose she later borrows $15,000 against $12,000 of gain; the $12,000 is taxable income that year, where a loan from an ordinary policy would not be. Hypothetical figures.
Applies to: Life InsuranceWhole Life Insurance