A life insurance policy fails the seven-pay test and is classified as a modified endowment contract (MEC). Which statement about withdrawals from a MEC is correct?

Why A is correct

A MEC results when premiums paid into a policy exceed the seven-pay test limit. Distributions from a MEC are taxed on a last-in, first-out, or LIFO, basis, meaning gains are withdrawn and taxed before the cost basis, and withdrawals before age 59 1/2 generally incur a 10 percent penalty. The death benefit, however, remains income tax free to the beneficiary. The MEC rules remove the tax advantages of funding a policy too quickly and are a frequent taxation exam point.

Why the other options are wrong

• B) MEC distributions are not tax-free; gains come out first under LIFO and are taxed as ordinary income. The penalty is specifically designed to discourage using MECs as tax-favored investment vehicles.
• C) FIFO treatment, recovering cost before gain, applies to ordinary non-MEC policies, not to modified endowment contracts. Gains are withdrawn and taxed first, leaving the tax-free return of principal until the end.
• D) The death benefit of a MEC is still excluded from the beneficiary's gross income; only withdrawals are taxed and penalized. Ordinary non-MEC policies recover cost before gain on a FIFO basis, but MECs reverse that order.

Memory hook

MEC = gains out first, LIFO, plus a 10% penalty before 59 1/2. Overfund fast, pay tax faster.