Tennessee Life Producer Practice Exam

What consequence does a Modified Endowment Contract typically have on life insurance benefits?

1. Higher premium costs

2. Tax implications on withdrawals

3. Guaranteed income for life

4. No impact on benefits

The correct answer is: Tax implications on withdrawals

A Modified Endowment Contract (MEC) significantly impacts the tax treatment of the policy, particularly concerning any withdrawals or loans taken against the cash value. When a life insurance policy is classified as a MEC, it is subject to different tax rules than traditional policies. Specifically, if a policyholder takes a withdrawal from a MEC, the distributions are taxed on a last-in, first-out (LIFO) basis, meaning the earnings within the policy are taxed before any of the original investment (premiums) is returned. Additionally, if the policyholder is under the age of 59 ½ at the time of withdrawal, they may also face a 10% penalty tax on the earnings portion of the withdrawal. This tax implication is essential for policyholders to understand as it can influence their financial planning and decisions regarding accessing the cash value of their life insurance. In contrast, traditional life insurance policies that do not classify as MECs typically allow for tax-free withdrawals to the extent of the premiums paid. Therefore, the MEC designation has a crucial impact on the taxation of benefits accessed during the policyholder's lifetime.