South Carolina Insurance Practice Exam

Pre-death distributions from a modified endowment contract (MEC) receive different tax treatment largely because these types of contracts are designed primarily as investment vehicles rather than traditional life insurance policies. A MEC is a specific type of life insurance policy that has been funded with an excessive amount of premiums and therefore fails the "7-pay test," which is a measure used to determine whether a policy meets the definition of a life insurance contract for tax purposes.

As a result of this designation, any distributions from a MEC, such as withdrawals or loans against the cash value, are subject to less favorable tax implications compared to non-MECs. Specifically, the earnings portion of any distributions is taxable as ordinary income, and if the policyholder is under the age of 59½, there could be an additional penalty tax. This tax treatment contrasts with non-MEC policies, where distributions are generally more favorable due to the tax-free nature of death benefits and potentially tax-deferred cash value growth.

Understanding this distinction is crucial for those using life insurance as a financial planning tool, as it influences decisions regarding how much to fund a policy and when to access its cash value.