South Carolina Insurance Practice Exam

Why do pre-death distributions from a modified endowment contract (MEC) receive different tax treatment?

1. They are only for emergency use

2. They tend to be investment vehicles

3. They are regulated by different agencies

4. They only cover medical expenses

The correct answer is: They tend to be investment vehicles

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.