Distributions from a Modified Endowment Contract (MEC) are taxed using which method?

Distributions from a Modified Endowment Contract (MEC) are taxed using which method?

• A. First-in, first-out (FIFO)
• B. Tax-free under all circumstances
• C. Proportional tax treatment
• D. Last-in, first-out (LIFO)

Answer: (D)

When a life insurance policy becomes a Modified Endowment Contract, distributions follow a last-in, first-out approach. This means the portion of a withdrawal that comes from the policy’s earnings (the inside buildup) is taxed as ordinary income in the year you take the distribution. The portion drawn from your cost basis, which represents your contributions to the policy, is tax-free. For example, if the policy has a basis of 10,000 and earnings of 6,000 (total cash value 16,000), taking an 8,000 distribution would first tap into the 6,000 of earnings and tax that amount as ordinary income, with the remaining 2,000 coming from basis and being tax-free. This LIFO treatment contrasts with the FIFO approach used in some other contexts, where basis is withdrawn first. If you’re under 59½, an additional 10% early withdrawal penalty may apply unless an exception is met.

When a life insurance policy becomes a Modified Endowment Contract, distributions follow a last-in, first-out approach. This means the portion of a withdrawal that comes from the policy’s earnings (the inside buildup) is taxed as ordinary income in the year you take the distribution. The portion drawn from your cost basis, which represents your contributions to the policy, is tax-free.

For example, if the policy has a basis of 10,000 and earnings of 6,000 (total cash value 16,000), taking an 8,000 distribution would first tap into the 6,000 of earnings and tax that amount as ordinary income, with the remaining 2,000 coming from basis and being tax-free. This LIFO treatment contrasts with the FIFO approach used in some other contexts, where basis is withdrawn first.

If you’re under 59½, an additional 10% early withdrawal penalty may apply unless an exception is met.