Texas Life Agent Practice Exam

What tax consequence results from a cash withdrawal from a Modified Endowment Contract?

1. Tax-exempt withdrawal

2. Ordinary income tax on the withdrawal

3. Capital gains tax

4. 10% penalty on the entire amount

The correct answer is: Ordinary income tax on the withdrawal

When a policyholder makes a cash withdrawal from a Modified Endowment Contract (MEC), the amount withdrawn is subject to ordinary income tax. This tax consequence arises because MECs are structured in such a way that they do not allow for tax-free withdrawals to the same extent as traditional life insurance policies. The first dollars taken out are considered gains (the accumulated interest within the contract), which are taxed as ordinary income. Additionally, any amount withdrawn beyond the owner's basis (the premiums paid into the contract) also incurs taxation. Thus, the funds taken from a MEC are not tax-exempt and will raise tax implications for the policyholder. While there may be penalties under certain conditions for early withdrawal, the fundamental tax consequence of such a withdrawal is the ordinary income tax on the amount taken.