PSI Ohio Insurance Practice Exam

How are withdrawals treated for taxation if a life insurance policy is classified as a Modified Endowment Contract (MEC)?

1. On a first-in first-out (FIFO) basis

2. On a last-in first-out (LIFO) basis

3. As ordinary income

4. They are tax-exempt

The correct answer is: On a last-in first-out (LIFO) basis

When a life insurance policy is classified as a Modified Endowment Contract (MEC), withdrawals are treated on a last-in first-out (LIFO) basis. This means that the most recent contributions to the policy are considered to be withdrawn first. Since the money contributed to a MEC is typically after-tax dollars, the portion of the withdrawal that represents those contributions is not taxed upon withdrawal. However, any earnings withdrawn are considered taxable income, as they are seen as a return on investment. This taxation treatment for MECs alters the usual tax treatment for withdrawals from life insurance. In a standard policy, withdrawals might follow a first-in first-out (FIFO) basis, where contributions are considered to be withdrawn before the earnings, allowing for tax-free access to the initial investment. But because MECs are specifically designed to be more aligned with investment products rather than traditional life insurance, they are subject to stricter tax rules, resulting in the LIFO treatment and the potential for taxable income when withdrawals exceed the original premiums paid. Understanding this LIFO framework is crucial for anyone managing or considering a MEC, as it affects the financial planning surrounding withdrawals, taxation, and overall policy performance.