If a policy is determined to be a Modified Endowment Contract (MEC), what are the tax implications for funds received under the policy?

A policy classified as a Modified Endowment Contract (MEC) has specific tax implications that are important to understand. When funds are received under a MEC, the taxation follows a specific order: any amounts that are withdrawn or distributed are considered taxable income to the policyholder to the extent of any gain in the policy.

This means that the premiums paid into the policy are not taxable, but once the amount exceeds the tax basis (the total premiums paid), the gains become taxable as ordinary income. This tax treatment is different from traditional life insurance policies, where the death benefit is typically received tax-free by beneficiaries.

Understanding this tax treatment is crucial for policyholders because it can significantly affect the net amount they receive if they access cash value before passing the policy to beneficiaries. Therefore, knowing that distributions are taxable first as income underscores the importance of careful planning around withdrawals from a MEC.