What occurs when a policy is classified as a Modified Endowment Contract (MEC)?

When a life insurance policy is classified as a Modified Endowment Contract (MEC), it is subject to specific tax treatment that impacts how the policyholder can access its value. The classification of a policy as a MEC generally occurs when the premiums paid into the policy exceed the limits set by IRS guidelines for life insurance. As a result, when policyholders take loans or make withdrawals from a MEC, those transactions are taxed on a last-in, first-out (LIFO) basis. This means that any gain in the policy will be taxed as ordinary income before returning any of the policyholder's basis (the amounts they paid in).

This tax treatment is important for policyholders to understand, as it affects their financial planning and the amount they may eventually receive from the policy. The classification does not impact the policy's death benefit, the ability to accumulate cash value, or restrictions on conversions to an annuity. Understanding these implications is crucial for individuals considering a MEC in their financial strategies.