A life insurance policy fails the seven-pay test and is classified as a modified endowment contract (MEC). Which statement about withdrawals from a MEC is correct?

Why A is correct

A MEC results when premiums paid into a policy exceed the seven-pay test limit. Distributions from a MEC are taxed on a last-in, first-out, or LIFO, basis, meaning gains are withdrawn and taxed before the cost basis, and withdrawals before age 59 1/2 generally incur a 10 percent penalty. The death benefit, however, remains income tax free to the beneficiary. The MEC rules remove the tax advantages of funding a policy too quickly and are a frequent taxation exam point.

Why the other options are wrong

• B) MEC distributions are not tax-free; gains come out first under LIFO and are taxed as ordinary income. The penalty is specifically designed to discourage using MECs as tax-favored investment vehicles.
• C) FIFO treatment, recovering cost before gain, applies to ordinary non-MEC policies, not to modified endowment contracts. Gains are withdrawn and taxed first, leaving the tax-free return of principal until the end.
• D) The death benefit of a MEC is still excluded from the beneficiary's gross income; only withdrawals are taxed and penalized. Ordinary non-MEC policies recover cost before gain on a FIFO basis, but MECs reverse that order.

Memory hook

MEC = gains out first, LIFO, plus a 10% penalty before 59 1/2. Overfund fast, pay tax faster.

Why A is correct

A policy becomes a MEC under IRC §7702 when it is funded faster than seven equal annual premiums would be needed to pay up the policy. The consequences apply to distributions: withdrawals and loans are taxed on a LIFO basis, meaning taxable gain comes out first, and a 10% penalty tax applies to distributions before age 59½, with limited exceptions. The death benefit, however, remains income-tax free to the beneficiary. MEC status does not make premiums deductible or convert loans into tax-free events.

Why the other options are wrong

• B) Loans from a MEC are taxable distributions under LIFO, unlike ordinary policies where loans are generally tax-free.
• C) The death benefit of a MEC is still received income-tax free under IRC §101.
• D) Life insurance premiums are generally not tax-deductible, and MEC status does not change that.

Memory hook

MEC = overfunding too fast. Payback: LIFO taxes plus a 10% early-withdrawal bite.

Why A is correct

A modified endowment contract (MEC) is created when a life insurance policy is funded faster than the seven-pay test permits. Because the contract is overfunded as an investment, withdrawals and loans are taxed on a last-in, first-out (LIFO) basis, meaning taxable gain is distributed first, and distributions before age 59 and a half are subject to a 10% penalty. The death benefit, however, remains income-tax-free to the beneficiary under IRC Section 101(a), and the contract continues to operate as life insurance.

Why the other options are wrong

• B) MEC status does not make the death benefit taxable; the beneficiary still receives the proceeds income-tax-free. The beneficiary's receipt of proceeds is excluded under Section 101(a) even when the policy is a MEC.
• C) A MEC is still a life insurance contract, not an annuity; it keeps the death benefit and the policy's features. The contract keeps the death benefit and continues to be taxed as life insurance.
• D) Policy loans are still permitted from a MEC, but they are treated as taxable distributions under the LIFO rule, which is why the penalty can apply. Loans remain available but lose their tax-free character, which is exactly the adverse consequence described.

Memory hook

Stuff a policy with cash too fast, it becomes a MEC, and gain comes out first with a penalty kick.