Massachusetts State Life Insurance Practice Exam

How is the gain from the surrender of a modified endowment contract (MEC) treated for federal income taxes?

1. The gain is tax-free if kept for more than 10 years

2. The gain is treated as taxable income and subject to a penalty

3. Only part of the gain is taxable

4. No taxes or penalties are applied to this gain

The correct answer is: The gain is treated as taxable income and subject to a penalty

When it comes to modified endowment contracts (MECs), the tax treatment of gains upon surrender is particularly important for policyholders to understand. In the case of MECs, any gain realized from the surrender is typically treated as taxable income. This means that the amount of gain will be included in the policyholder's total taxable income for the year, which could potentially increase their taxable income bracket. Additionally, there is often a penalty associated with taking distributions from a MEC if the policyholder is under the age of 59½. This penalty is usually an additional 10% on the taxable amount, reflective of the IRS regulations aimed at discouraging early withdrawals from life insurance contracts. Thus, the correct answer outlines that not only is the gain taken as taxable income, but it is also subject to penalties if certain conditions are met, making it important for individuals to be aware of these implications when considering surrendering their MECs.