What is the tax implication of a modified endowment contract that fails to meet the seven-pay test?

A modified endowment contract (MEC) is a type of life insurance policy that has failed to meet the seven-pay test, which is a limit on the amount of premium paid into the policy during the first seven years. When a policy is classified as a MEC, the tax implications regarding distributions change significantly.

Pre-death distributions from a MEC are typically taxable because they are treated as distributions from a life insurance policy that does not meet favorable tax treatment criteria. Instead of enjoying tax-free growth or tax-free withdrawals up to the basis (the amount paid in premiums), distributions from MECs are taxed on a Last In, First Out (LIFO) basis. This means that any gains in the policy are taxed first as ordinary income, while the return of premium remains tax-free.

Additionally, if the policyholder is under the age of 59½, then the distributions from a MEC may also incur a 10% early withdrawal penalty on the taxable portion, making it less favorable compared to a traditional life insurance policy that meets the seven-pay test.

This understanding illustrates the impacts that the status of being classified as a MEC has on the tax treatment of pre-death distributions, helping to clarify why the correct answer relates to the taxability of such distributions