Annuities✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
If a life insurance policy becomes a modified endowment contract (MEC), withdrawals from the policy are:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
A modified endowment contract loses the favorable tax treatment of ordinary life insurance. Under IRC Section 7702, distributions from a MEC are taxed on a last-in-first-out basis — gain comes out first and is taxable — and the taxable portion is subject to a 10 percent penalty if the policyowner is under age 59 and a half. Policy loans from a MEC are also treated as taxable distributions. The death benefit, however, remains income-tax-free.
Why the other options are wrong
- B) Loans from a MEC are distributions, not tax-free loans; the LIFO and penalty rules apply to them.
- C) MEC distributions are ordinary income, not capital gain.
- D) The 10 percent penalty applies to taxable MEC distributions before age 59 and a half; it does not disappear at any age.
Memory hook
MEC = the IRS flips your policy to LIFO and adds a 10% toll before 59½. Keep the 7-pay leash on.