Which statement correctly describes the tax treatment of distributions from a Modified Endowment Contract (MEC)?

Why A is correct

For a Modified Endowment Contract, distributions, including loans, are taxed on a LIFO basis, meaning gains are distributed and taxed first, and a 10% additional tax applies to distributions taken before age 59½ unless an exception applies. This removes the tax advantage that ordinary life policies enjoy, where policy loans are generally tax-free. The death benefit of a MEC remains income-tax-free to the beneficiary, so the MEC rules mainly affect living distributions from the policy. The combination of LIFO ordering and the penalty makes large MEC distributions costly.

Why the other options are wrong

• B) MEC distributions are taxable in part, so they are not completely tax-free as the option suggests. Gain is recognized first under the LIFO rule, making at least part of any distribution taxable.
• C) Loans from a MEC are treated as distributions and are taxable, unlike loans from a non-MEC policy. The loan feature loses its tax advantage once MEC status applies, and gains may also face a penalty for early withdrawal.
• D) FIFO applies to withdrawals from a non-MEC policy; MECs are specifically taxed on a LIFO basis. The ordering rule is reversed for MECs, which is the source of the adverse tax result.

Memory hook

MEC = LIFO in, plus a 10% penalty before 59½. The loans are no longer free rides.