An insured dies while owning a policy that was classified as a Modified Endowment Contract. The death benefit paid to the beneficiary is, for federal income tax purposes:

Why C is correct

MEC status affects the taxation of distributions made while the owner is living — it does not change the treatment of the death benefit. Under IRC §101(a), life insurance proceeds paid by reason of the insured's death remain excluded from the beneficiary's gross income even if the policy is a MEC. The LIFO rule and the 10% penalty apply to lifetime distributions and loans, but the beneficiary still receives the death benefit free of federal income tax. The policy's MEC status is an important compliance warning, but death proceeds stay protected.

Why the other options are wrong

• A) The death benefit is not ordinary income to the beneficiary; §101(a) continues to exclude death proceeds from income even when the policy is a MEC. MEC status does not change this rule.
• B) There is no gain-over-premiums computation at death; the full death benefit is excluded from the beneficiary's income regardless of premiums paid. The exclusion is total. No basis arithmetic is done.
• D) The beneficiary's relationship to the insured does not affect the exclusion; the death benefit is tax-free to any named beneficiary. Any named beneficiary qualifies. The relationship is irrelevant to the exclusion.

Memory hook

MEC penalizes living withdrawals, never the death claim — the beneficiary still sees tax-free money.