South Carolina Insurance Practice Exam

What are the tax consequences of a Modified Endowment Contract?

1. All distributions are tax-free

2. Pre-death distributions will become taxable

3. Only interest earned is taxable

4. Distributions can be withdrawn without taxes at any time

The correct answer is: Pre-death distributions will become taxable

A Modified Endowment Contract (MEC) has specific tax consequences that differ from those of traditional life insurance policies. When a policy is classified as a MEC, it loses the favorable tax treatment that applies to standard life insurance policies. In the case of a MEC, pre-death distributions – such as withdrawals or loans taken against the cash value – are subject to taxation. Specifically, any money withdrawn is considered taxable income to the extent that it exceeds the policyholder's basis (i.e., the amount they have paid into the policy). This means that the portion of the withdrawal that represents earnings is taxable, leading to potential tax liabilities on distributions made before the insured's death. This classification as a MEC typically occurs when the premiums paid into the policy exceed the limits set by the Internal Revenue Code, indicating that the policy is designed more for investment than for providing death benefits. Therefore, while standard policies allow for tax-free distributions up to the basis, MECs do not enjoy that same benefit, making the correct understanding of their tax implications essential for policyholders.