A life insurance policy becomes a modified endowment contract (MEC) under IRC Section 7702. Which statement about a MEC is correct?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
A policy becomes a modified endowment contract when premiums exceed the 7-pay limit under IRC Section 7702. The death benefit remains generally income tax free under IRC Section 101(a). However, distributions and loans from a MEC are taxed on a LIFO basis, meaning the gain is taxed first, and a 10% additional tax applies to taxable amounts taken before age 59 1/2, subject to certain exceptions. MEC status therefore removes the favorable loan and withdrawal treatment of a life policy while preserving the tax-free death benefit. Agents should warn clients that funding a policy too heavily can create MEC status.
Why the other options are wrong
- MEC status does not make the death benefit taxable; the death benefit remains income tax free under IRC Section 101(a).
- Cash value growth continues to grow on a tax-deferred basis, but MEC status does not convert that deferral into permanent tax exemption.
- Life insurance premiums are generally not tax deductible, whether or not the policy is a MEC.
Memory hook
MEC = piggybank status revoked for withdrawals, but the death benefit keeps its tax-free badge.