An owner takes a loan against the cash value of a policy that has become a Modified Endowment Contract (MEC). For federal income tax purposes, the loan amount is treated as:

Why D is correct

Under IRC §7702A, amounts received as loans from a MEC are treated as distributions, not as true loans. This is a critical distinction from a non-MEC policy, where a loan is a nontaxable borrowing against the cash value. Because MEC loans are distributions, they are taxed under the LIFO rule (gain first) and may also be subject to the 10% penalty on distributions taken before age 59½. The MEC penalty structure is designed to discourage the use of life insurance as a tax-advantaged investment vehicle.

Why the other options are wrong

• A) A MEC loan is not tax-free; the statute treats loans from a MEC as distributions, so they are taxable under the gain-first LIFO rule. This is the key difference from a non-MEC loan.
• B) Repayment timing does not matter; the loan is a taxable distribution when taken, regardless of whether the owner later repays it. The tax event is the taking of the loan.
• C) There is no 5% penalty for MEC loans; the applicable penalty is the 10% early-distribution penalty that applies before age 59½. 10% is the correct penalty figure. Five percent is never right.

Memory hook

Borrow from a MEC and the IRS sees a distribution — MEC loans are taxable, plain and simple.