Final Answer:
A "premature" distribution from a modified endowment contract (MEC) incurs a penalty tax of 40%.
The correct option is 4.
Step-by-step explanation:
A "premature" distribution from a Modified Endowment Contract (MEC) incurs a penalty tax of 40%. This penalty is applied to any earnings withdrawn from the MEC before the age of 59 1/2. The MEC is a special type of life insurance contract with tax advantages, and it is subject to strict limits on premium payments. If these limits are exceeded, the contract loses its favorable tax treatment, and withdrawals become subject to the substantial penalty tax.
The penalty tax of 40% is a significant deterrent designed to encourage policyholders to maintain the MEC as a long-term financial planning tool rather than using it as a short-term investment vehicle. The rationale behind this penalty is to discourage policyholders from abusing the tax benefits associated with MECs and to promote their use as a means of long-term financial security. It's crucial for policyholders to be aware of these penalties and carefully plan their withdrawals to avoid unnecessary tax implications.
To calculate the penalty for a premature distribution from an MEC, you would take the amount of the distribution and multiply it by the penalty rate of 40%. For example, if a policyholder withdraws $10,000 prematurely from an MEC, the penalty tax would be $4,000 (10,000 x 0.40). This substantial penalty emphasizes the importance of understanding the terms and conditions of MECs and making informed financial decisions to maximize the benefits while avoiding unnecessary taxes.
Thus, the correct option is 4.