Washington Life Producer Practice Exam

Under a Modified Endowment Contract, what tax implications can one expect from pre-death distributions?

1. They are tax-free

2. They will become taxable

3. They incur a penalty

4. They retain cash value only

The correct answer is: They will become taxable

Under a Modified Endowment Contract (MEC), the key tax implication regarding pre-death distributions is that these distributions will become taxable. A MEC, which generally arises from a life insurance policy that has been overfunded according to IRS guidelines, alters the way funds can be accessed. When a policy is classified as a MEC, any cash withdrawals or loans taken against the policy are taxed as ordinary income up to the amount of the policy's gain. This means that if you access the cash value before death, rather than being tax-free as would typically be the case with a standard life insurance policy, you will incur tax liabilities. This creates a significant difference in tax treatment compared to traditional life insurance policies where cash value distributions can often be made without tax consequences. Additionally, if distributions are taken before the policyholder reaches age 59½, they might also incur a 10% federal tax penalty on the withdrawal amount. However, the primary takeaway is that pre-death distributions from a MEC result in taxable income. Understanding these tax implications is crucial for anyone considering or managing a Modified Endowment Contract.