Modified Endowment Contract

A Modified Endowment Contract (MEC) results when a policy is:

1. A.Overfunded beyond the 7-pay limitCorrect - excess funding triggers MEC status.
2. B.Underfunded and about to lapseExactly backwards. MEC status is the penalty for putting money into the contract too quickly, not for putting in too little; an underfunded policy faces lapse, which is a separate problem.
3. C.Converted from termConversion changes the type of coverage and does not by itself trigger MEC status. What matters is how fast premium goes in relative to the seven-pay limit, whatever the policy's history.
4. D.Owned by a businessWho owns the policy does not determine MEC status. Corporate-owned coverage raises its own tax questions, but the seven-pay test looks only at the pace of funding.

Why: A MEC arises when a policy is funded faster than the 7-pay test allows, changing the tax treatment of loans and withdrawals.

A life insurance contract that fails the 7-pay test is classified as a:

1. A.Group policyDescribes how a policy is marketed and to whom, not how it is taxed. Failing the funding test changes the tax treatment of distributions; it does not move the contract into a different distribution channel.
2. B.Term policyTerm insurance accumulates no meaningful cash value, so the seven-pay limit has nothing to bite on. The classification in question applies to cash-value contracts that can be stuffed with premium.
3. C.Fixed annuityNot life insurance, so the seven-pay test never reaches it. Annuity distributions are already taxed on a gain-first basis, which is probably why the two get linked, but that is a permanent feature of annuities rather than a status a life policy falls into.
4. D.Modified Endowment Contract (MEC)Correct - overfunding past the 7-pay limit creates a MEC.

Why: A Modified Endowment Contract (MEC) loses favorable tax treatment - loans and withdrawals are taxed on a gain-first basis and may incur penalties.

Endymion Blackwood borrows against the cash value of his in-force whole life policy, which is not a modified endowment contract, and never repays the loan. Which statement is correct?

1. A.The loan proceeds are taxable to him as ordinary income in the year that he receives them.Wrong. Borrowing against an in-force policy that passes the seven-pay test is not a distribution at all.
2. B.The insurer must report the loan as a partial surrender once interest begins to accrue on it.Wrong. Accruing interest increases the balance owed but does not convert a borrowing into a withdrawal.
3. C.The loan permanently reduces his cost basis in the policy by the amount that he borrowed.Wrong. Basis reflects premiums paid net of untaxed distributions, and a loan is neither.
4. D.The loan is not currently taxable, and the unpaid balance plus interest reduces the death benefit.Correct. The insurer takes its security out of the proceeds, which is how it lends without triggering a taxable event.

Why: A loan taken against an in-force policy that is not a modified endowment contract is a borrowing, not a distribution, so no income is recognised when the proceeds are received. The insurer secures itself by charging interest and by reducing any death benefit or surrender proceeds by the outstanding balance plus accrued interest. Because nothing has been withdrawn, the cost basis of the owner is untouched by the borrowing. The picture changes if the policy lapses or is surrendered with a loan outstanding, since the loan is then treated as received and any gain becomes taxable.

A life insurance policy becomes a Modified Endowment Contract (MEC) when it...

1. A.Is held for more than seven yearsHolding period alone does not create a MEC; overfunding does.
2. B.Is funded faster than the 7-pay test allowsCorrect — failing the 7-pay test makes a policy a MEC.
3. C.Is converted from term to whole lifeConversion does not by itself create a MEC; excessive premium funding does.
4. D.Names an irrevocable beneficiaryBeneficiary designation has nothing to do with MEC status.

Why: A policy is a MEC when it is funded faster than the 7-pay test allows. Once classified as a MEC, living distributions and loans are taxed on gains first (LIFO), with a 10 percent penalty before age 59 and a half.