Pre-death distributions from a modified endowment contract (MEC) receive different tax treatment than other life insurance policies because a. the MEC has tax deductible premiums b. the MEC is considered an illegal product c. the MEC tends to be an investment vehicle d. the MEC does not accumulate cash value
The Correct Answer and Explanation is:
The correct answer is c. the MEC tends to be an investment vehicle.
A Modified Endowment Contract (MEC) is a type of life insurance policy that fails to meet the IRS requirements for a life insurance contract under the 7-pay test, which limits the amount of premiums that can be paid into the policy in the first seven years. When the premiums exceed this threshold, the policy is classified as an MEC, which triggers different tax treatment.
The reason pre-death distributions from an MEC receive different tax treatment compared to other life insurance policies is that MECs are often used as an investment vehicle. The structure of an MEC allows for a significant cash accumulation within the policy, which can then be accessed by the policyholder through withdrawals and loans. However, the IRS treats these policies differently because they are designed to build wealth rather than provide traditional life insurance coverage.
For a typical life insurance policy, the cash value grows on a tax-deferred basis, and policyholders can take out loans against the cash value or make withdrawals without triggering immediate taxation. However, in the case of an MEC, any distributions (such as loans or withdrawals) are subject to income tax on the earnings (interest or gains), rather than being treated as a return of premiums (which would generally be tax-free).
In addition, withdrawals from an MEC are subject to the LIFO (Last In, First Out) rule, meaning that the most recent premiums paid (which are often the largest) are considered to be the first money withdrawn, and are taxed as income. If the policyholder is under age 59½, they may also be subject to a 10% penalty on the taxable portion of the distribution.
In summary, because the MEC is primarily used as an investment vehicle, the tax treatment is more stringent, and policyholders face income tax on any gains, which contrasts with the more favorable tax treatment given to other life insurance policies.