How does a modified endowment contract (MEC) impact tax treatment?

A modified endowment contract (MEC) is classified under tax law primarily based on how quickly it accumulates cash value in relation to the premiums paid. This classification affects the tax treatment of withdrawals and loans taken against the policy. In the case of a MEC, any amount withdrawn or borrowed from the policy is subject to taxation. Specifically, the gains (interest or investment growth) are taxed as ordinary income when received, and if the policyholder is under age 59½, a 10% penalty may also apply to the gains. This tax treatment is less favorable compared to standard life insurance policies, where withdrawals can often be taken on a tax-free basis up to the amount of the premiums paid.

The other options highlight misconceptions about MECs or do not accurately capture their tax treatment. While some policies offer tax-free benefits upon death (which is true for both MECs and traditional life insurance), the tax implications when it comes to accessing cash value are a key distinguishing feature of MECs. Therefore, understanding that a MEC indeed results in less favorable tax treatment for those who withdraw or borrow funds is crucial for anyone considering such a policy.