What happens to the tax advantages of a life insurance policy when it is classified as a Modified Endowment Contract (MEC)?

When a life insurance policy is classified as a Modified Endowment Contract (MEC), standard tax benefits associated with life insurance are significantly impacted. A MEC arises when a policy is overfunded, meaning that the premiums paid exceed certain limits set by the IRS for a life insurance product. Once a policy is classified as a MEC, the favorable tax treatment typically provided to permanent life insurance policies is altered.

One major change is that any withdrawals or loans taken from the cash value of the policy may be subject to income tax, which is not the case for non-MEC life insurance policies. Furthermore, if the policyholder withdraws money or takes a loan and then dies, the death benefit could potentially be taxable to the extent that there is an outstanding loan or if gains are realized. This means that the tax advantages normally enjoyed, such as tax-deferred growth of cash value and tax-free distributions, are lost under MEC classification. Thus, the tax implications of MECs make them a crucial point of consideration for policyholders.