South Carolina Insurance Practice Exam

Which of these is NOT subject to income taxation under a Modified Endowment Contract (MEC)?

1. Death benefit

2. Cash withdrawals

3. Policy loans

4. Interest earned on cash value

The correct answer is: Death benefit

The death benefit of a Modified Endowment Contract (MEC) is not subject to income taxation. This means that when the insured passes away, the beneficiaries receive the death benefit free from federal income tax, regardless of whether the policy is classified as a MEC or not. This tax treatment aligns with the general principle that life insurance death benefits are typically exempt from income tax, providing a financial advantage for the policyholder's beneficiaries. In contrast, cash withdrawals and policy loans from a MEC can trigger taxable events, wherein the amount withdrawn or borrowed may be subject to income tax, especially if premiums exceed certain limits. Additionally, any interest earned on the cash value component of the MEC is subject to income taxation as it accumulates. Understanding this differentiation is essential for policyholders managing their life insurance policies and planning their finances in the context of taxation.