Final answer:
An adjustable life policy classified as a Modified Endowment Contract (MEC) is subject to strict tax rules, which could make withdrawals or loans taxable and potentially incur a 10% federal tax penalty if distributions are taken before the age of 59 and a half. This classification comes into effect when IRS premium payment tests are not met, preventing life insurance from being used as a tax shelter.
Step-by-step explanation:
If an adjustable life policy is classified as a Modified Endowment Contract (MEC), the result is that the policy is subject to different tax rules compared to standard life insurance contracts. Typically, life insurance policies such as cash-value (whole) life insurance combine a death benefit with a savings component, where a cash value accumulates. This cash value can often be borrowed against or even withdrawn by the policy owner with favorable tax treatment.
However, if the policy is deemed a MEC, withdrawals, loans, and other distributions from the cash value become potentially taxable events. If you take out cash from a MEC before age 59 and a half, you may also be subject to a 10% federal tax penalty on top of the income taxes. This is due to IRS regulations that designate a policy as a MEC if it fails to pass certain premium payment tests. The purpose behind these tests is to prevent people from using life insurance as a tax shelter for investment-like vehicles.
Impact of MEC on Life Insurance Policies
The reclassification to a MEC affects the policy in several key ways:
- Distributions are treated as income first, as opposed to a return of premium, which can result in higher taxes.
- Policy loans and partial surrenders are taxable to the extent that there is gain in the policy.
- The 10% federal tax penalty applies to distributions taken before age 59 and a half, except in cases of disability or certain other exceptions.
Because of these changes, it's essential for policyholders to understand whether their life insurance policies could be classified as MECs and the financial implications thereupon.