Taxation✓ Verified · outline & fact-checked · Sep 2026Difficulty 3/5
A life insurance policy fails the seven-pay test and becomes a modified endowment contract (MEC). What happens to withdrawals from the policy?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
A MEC, defined in IRC §7702A, is a life policy whose premiums exceed the seven-pay limit. MEC status removes the favorable treatment of cash-value distributions: withdrawals and loans are taxed on a LIFO basis, meaning distributions are taxable income to the extent of gain before any return of basis, and a 10% additional tax applies on taxable amounts taken before age 59½. The death benefit, however, remains income-tax free under IRC §101. Losing the death-benefit exclusion, FIFO treatment, or treating the contract as no longer life insurance are all incorrect.
Why the other options are wrong
- B) MEC distributions are not tax-free. Because the contract is overfunded, distributions are treated as gain first and are taxable to the extent of the gain.
- C) MECs are taxed on a LIFO basis — gain comes out first. FIFO treatment, where basis is recovered before gain, applies only to non-MEC policies.
- D) The death benefit of a MEC remains excludable from income under IRC §101. MEC status changes the taxation of distributions, not the tax-free nature of the death benefit.
Memory hook
MEC flips the piggy bank: gains jump out first and a 10% fine may follow before 59½.