Under a Modified Endowment Contract, what are the likely tax consequences of pre-death distributions?

Under a Modified Endowment Contract (MEC), pre-death distributions are generally subject to taxation. The key feature of a MEC is that it fails to meet the seven-pay test, which determines whether a life insurance contract is classified as a MEC. Because of this status, distributions taken from the policy are taxed as ordinary income to the extent that they exceed the policyholder's cost basis in the contract.

When a policyholder takes a distribution from a MEC, it triggers tax implications that would not normally apply to a standard life insurance policy. If the cash value of the contract is withdrawn, any gain (the amount withdrawn that exceeds the premiums paid into the contract) is taxed as income. This means that the earnings portion of any pre-death withdrawals will be taxable to the policyholder.

In addition to the income taxes, if the individual is under the age of 59½ at the time of the distribution, they may also incur a 10% federal penalty tax on the taxable portion of the distribution. This aspect reinforces the financial planning considerations surrounding MECs, as policyholders need to be mindful of the tax consequences when accessing their funds prior to death.