Rhode Island Life Insurance Practice Exam

What is the consequence of a policy becoming a Modified Endowment Contract (MEC)?

1. It becomes easier to access cash value

2. It will lose many of its tax advantages

3. It provides higher death benefits

4. It restricts the ability to borrow against the cash value

The correct answer is: It will lose many of its tax advantages

When a life insurance policy is classified as a Modified Endowment Contract (MEC), it loses many of the favorable tax advantages typically associated with life insurance products. Specifically, the IRS establishes guidelines that determine whether a policy is considered a MEC, primarily based on the premium payments made relative to the death benefit. If a policy fails the "7-pay test," meaning that the total premiums paid exceed the allowed amount within the first seven years, it is classified as a MEC. One significant consequence of this classification is that any withdrawals or loans taken from the policy become subject to taxation. Under normal circumstances, the cash value of a life insurance policy can be accessed tax-free through loans or withdrawals, provided the policy is not a MEC. However, once it is deemed a MEC, any distribution (including loans) will be taxed as income to the extent that there is gain in the policy, similar to how an annuity is taxed. This alters the tax treatment dramatically, and policyholders may face unexpected tax liabilities if they try to access funds. Therefore, the correct response highlights the critical impact that becoming a Modified Endowment Contract has on the tax-deferred status of the policy, which is a vital consideration for anyone looking to utilize the cash value or benefits of