Which action will generally result in a penalty tax from a modified endowment contract (MEC)?

A modified endowment contract (MEC) is a type of life insurance policy that has been funded with more premiums than allowed under the federal tax code guidelines. One of the main consequences of a policy being classified as a MEC is the tax implications that come into play when money is accessed.

When it comes to policy loans, accessing the cash value through loans results in a penalty tax if the insured is younger than 59 and a half years old. This penalty is a 10% additional tax on the amount taken as a loan, which is treated like taxable income. This is because MECs are designed to prevent individuals from using life insurance primarily as a short-term investment vehicle. Therefore, accessing money via policy loans is significant in that it triggers this penalty, distinguishing it sharply from other actions associated with a life insurance policy.

While partial withdrawals can have tax implications, they are generally treated more favorably than loans from a MEC. Cash value increases do not trigger taxes until there is a distribution, and premium overpayments might lead to the policy being classified as a MEC but do not result in immediate penalties on their own. Thus, the action that most directly leads to a penalty tax from a MEC is taking policy loans.