PSI Ohio Insurance Practice Exam

If a policy is determined to be a Modified Endowment Contract (MEC), what will the funds received under the policy be considered?

1. Tax-free gifts

2. Taxable income first

3. Capital gains

4. Tax-deferred income

The correct answer is: Taxable income first

When a life insurance policy is classified as a Modified Endowment Contract (MEC), it has specific tax implications that affect how funds withdrawn or loans taken from the policy are treated. Under IRS regulations, funds received from a MEC are considered taxable income first, meaning that any distributions would be subjected to income tax prior to returning the policyholder's previously paid premiums. This tax treatment arises because the MEC designation is primarily a measure to prevent individuals from using life insurance solely as an investment vehicle to gain tax benefits. In contrast, if a policy was not classified as a MEC, distributions could often be withdrawn up to the premiums paid without incurring taxes. However, because MECs do not enjoy the same favorable tax treatment, any gains are taxed immediately as income upon withdrawal or distribution. Understanding this classification and its implications is critical for policyholders and financial planners as they navigate the nuances of life insurance policies and tax liabilities.