A modified endowment contract is a form of life insurance whose cash value grows rapidly due to large premium payments during the first seven years of the policy's existence. Before 1988 in the United States, some policyholders took advantage of existing tax law to access their policies' earnings without paying taxes on them. In 1988, the law was changed to provide for taxation of amounts distributed from modified endowment contracts for any purpose other than payment of a death benefit to a beneficiary.
Cash value is a concept underlying whole life insurance policies and universal life insurance policies. Part of the periodic premium paid by the policyholder pays for the cost of insurance, and a small portion pays for the administrative costs of maintaining the policy. The balance is saved in a dedicated account called cash value, which grows from periodic contributions from premium payments, as well as from interest and dividends earned. That part becomes an asset of the policyholder that can be withdrawn (also decreasing the death benefit) or borrowed against at a preferential rate of interest. While a policy's cash value can also be withdrawn, either in whole or in part, fees imposed by the insurance company make this an unattractive alternative to a policy loan.
Traditionally, the proceeds of insurance are generally exempt from taxation. This applies not only to death benefits paid, but also to loans, partial withdrawals and total surrenders. Thus, a policyholder could borrow against the cash value accumulated in a life insurance policy and not pay taxes on any part of the proceeds.
In the high-interest period of the early 1980s, many policyholders took advantage of this situation by making large premium payments, far more than what was required to maintain their policies. Whatever wasn't required to maintain the policy in force was deposited into cash value, where it would grow at the then prevailing rates, which often approached 20% annually. After a few years of such growth, they'd take out tax-free policy loans and not repay them, thus benefiting from the high interest rates without paying taxes on the earnings.
In 1988, the United States Tax Code was changed to discourage this practice. It defined as a modified endowment contract any life insurance policy into which the premiums paid at any point during the first seven years exceeded guidelines. These guidelines were set using a “Seven Pay Test,” which basically defines the maximum allowable premium per year that would provide for the cost of insurance and modest growth of the cash value. If the total premiums paid at any point during that seven years exceeded the test's standard, the entire policy was defined as a modified endowment contract. Corrective action can be taken, but only during a short time frame; if not taken, the determination is irrevocable, and no subsequent action on the part of either the policyholder or the insurer can change it.
The tax law changes in 1988 did not outlaw the modified endowment contract, but successfully discouraged its use as a short-term savings vehicle by imposing income tax, and sometimes penalties, on any disbursements from cash value other than the death benefit. Most insurance companies will monitor their life insurance policies and alert policyholders if a policy at some point fails the seven-pay test and becomes a modified endowment contract.