West Virginia State Life Insurance Practice Exam

A policy becomes a Modified Endowment Contract (MEC). What is a significant consequence of this?

1. It will gain additional benefits

2. It will lose many of its tax advantages

3. It becomes unrenewable

4. It can only be converted to whole life

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

When a policy is classified as a Modified Endowment Contract (MEC), it faces significant tax implications primarily because it loses some of its favorable tax advantages that are typically associated with life insurance policies. One of the main features of a standard life insurance policy is the tax-deferred growth of cash value, which allows the policyholder to accumulate funds without immediate tax liabilities. However, once a policy becomes a MEC, the Internal Revenue Service (IRS) treats withdrawals and loans from the policy differently. Specifically, if the policyholder takes out loans or withdrawals, these amounts may be subject to income tax, and if the policyholder is under age 59½, they may also incur a penalty tax. This shift in tax treatment makes MECs less advantageous compared to non-MEC policies, which can provide tax-free loans and withdrawals under certain conditions. Thus, the primary consequence of a policy being classified as a MEC is the loss of many of its tax benefits.