A California resident owns a life insurance policy that is classified as a Modified Endowment Contract (MEC). For California personal income tax purposes, distributions from the MEC are:

Why C is correct

California's Personal Income Tax Law conforms to the federal MEC provisions, including the treatment of MEC distributions. Because the policy is a MEC, distributions (including loans) are taxed gain-first under the LIFO rule for California purposes, just as they are federally, and the 10% early-distribution penalty applies before age 59½. California does not carve out MEC contracts from its conformity to the Internal Revenue Code, so the owner cannot avoid state tax on MEC distributions by relying on the policy's life insurance status.

Why the other options are wrong

• A) Being a life insurance contract does not exempt MEC distributions; California conforms to the federal LIFO taxation of these distributions. Status alone does not protect the funds. The LIFO rule still applies.
• B) California does not apply a flat 5% rate to MEC distributions; it conforms to federal LIFO taxation and the 10% penalty instead. There is no flat 5% state tax.
• D) California does recognize MEC treatment; loans from a MEC are taxable distributions, not tax-free loans, for state purposes as well. California conformity covers MEC loans too. No loan escape hatch exists.

Memory hook

California signs on to MEC rules too — LIFO and the 10% penalty apply at the state level.