Which of the following statements accurately describes the taxation of withdrawals from a Modified Endowment Contract (MEC)?
- AAll withdrawals are fully taxable as ordinary income.
- BWithdrawals are tax-free up to the amount of premiums paid.
- CWithdrawals are taxed on a 'last-in, first-out' (LIFO) basis, and a 10% penalty may apply to gains before age 59½.
- DWithdrawals are taxed on a 'first-in, first-out' (FIFO) basis.
Show answer & explanationAnswer & explanation
Correct answer: C. Withdrawals are taxed on a 'last-in, first-out' (LIFO) basis, and a 10% penalty may apply to gains before age 59½.
MECs are treated less favorably than traditional life insurance for tax purposes. Withdrawals from an MEC are subject to 'last-in, first-out' (LIFO) taxation, meaning gains are considered withdrawn first and are therefore taxable. Additionally, a 10% penalty tax may apply to taxable distributions made before the policyholder reaches age 59½.
Why the other options are wrong
- A. Only the gains are taxable, not necessarily the entire withdrawal, and the penalty applies specifically to gains before age 59½, not all withdrawals.
- B. This describes non-MEC life insurance withdrawals up to basis; MECs do not have this benefit for gains.
- D. FIFO applies to non-MEC life insurance cash value withdrawals, where basis (premiums) are withdrawn first, tax-free.
Modified Endowment Contract (MEC)
A life insurance policy that fails the 7-pay test and loses some of its favorable tax treatment, specifically regarding withdrawals and loans, which are taxed on a 'last-in, first-out' (LIFO) basis and may be subject to a 10% penalty before age 59½.
- Fails the 7-pay test.
- Cash value withdrawals and loans are taxed LIFO.
- Gains are taxed first.
- 10% penalty on taxable distributions before age 59½.
- Death benefit remains tax-free.
Memory trick: MEC: LIFO and a penalty, non-MEC: FIFO and no penalty.