A Modified Endowment Contract (MEC) is defined as a policy that fails the seven-pay test. What are the tax consequences for distributions from a MEC?

A Modified Endowment Contract (MEC) is defined as a policy that fails the seven-pay test. What are the tax consequences for distributions from a MEC?

• A. Distributions are tax-free if the policy remains in force.
• B. Distributions are taxed as capital gains only.
• C. Distributions are taxed as ordinary income to the extent of gains; withdrawals before recovery of gains may be penalized in other contexts.
• D. MEC status converts all benefits to tax-deductible.

Answer: (C)

The key idea is that once a policy becomes a Modified Endowment Contract, distributions are taxed based on the gains first. Because the MEC status makes the contract behave, for tax purposes, like a non-qualified contract, any money you take out is considered to come from earnings before you recover your cost basis. So the portion of a withdrawal that represents gains is taxed as ordinary income. The portion that comes from your Premiums (your cost basis) is tax-free until all gains have been recovered. If you withdraw before you’ve recovered the gains, the taxable portion remains ordinary income (and in some contexts could incur penalties for early withdrawal). This is why the correct choice states distributions are taxed as ordinary income to the extent of gains.

The key idea is that once a policy becomes a Modified Endowment Contract, distributions are taxed based on the gains first. Because the MEC status makes the contract behave, for tax purposes, like a non-qualified contract, any money you take out is considered to come from earnings before you recover your cost basis. So the portion of a withdrawal that represents gains is taxed as ordinary income. The portion that comes from your Premiums (your cost basis) is tax-free until all gains have been recovered. If you withdraw before you’ve recovered the gains, the taxable portion remains ordinary income (and in some contexts could incur penalties for early withdrawal). This is why the correct choice states distributions are taxed as ordinary income to the extent of gains.