What are the tax consequences under a Modified Endowment Contract?

Pre-death distributions from a Modified Endowment Contract (MEC) can indeed become taxable. A Modified Endowment Contract is a type of life insurance policy that has not met the seven-pay test, meaning that the premiums paid exceed the allowable limits set by the IRS for tax-favored treatment. As a result, when money is withdrawn from the cash value of a MEC, it is subjected to income tax on gains first, before any basis is returned to the policyholder. This shifts the tax implications of distributions to a less favorable position compared to traditional life insurance policies, where cash value distributions may remain tax-free up to the amount of premiums paid.

In contrast, the other options refer to aspects that do not apply in the same way to MECs. For instance, interest on policy loans is generally not tax-deductible, and premium payments for life insurance are typically not tax-deductible. The condition about cash value not being able to be surrendered early does not align with the actual mechanics of MECs, as policyholders can indeed surrender their cash value, although tax implications may arise. Understanding these distinctions is essential for effectively managing the tax consequences associated with Modified Endowment Contracts.