What happens to a policy that becomes a Modified Endowment Contract (MEC)?

When a life insurance policy becomes a Modified Endowment Contract (MEC), it loses many of its tax advantages. A MEC is classified as such when the policy's premium payments exceed certain IRS limits, which are designed to prevent a policy from being used predominantly as a tax shelter.

As a result of this classification, the tax treatment of the policy changes significantly. For example, loans and withdrawals from a MEC are subject to taxation and may incur penalties if taken before the insured reaches age 59½. Additionally, the death benefit received by beneficiaries remains tax-free, but the accumulated cash value growth is taxed upon withdrawal, which is a shift away from the more favorable tax treatment offered to policies that do not fall into the MEC category.

This shift emphasizes the importance of proper premium structuring and understanding how policies are classified to avoid unintended tax consequences. Other choices are incorrect because they either suggest enhanced benefits or unchanged treatment, which is not aligned with the realities of a MEC designation.