What is the potential tax consequence of a modified endowment contract that fails the seven-pay test?

When a modified endowment contract (MEC) fails the seven-pay test, it triggers specific tax consequences regarding distributions from the policy. In this case, pre-death distributions, including withdrawals and loans, become taxable.

The key aspect of a MEC is that it is overfunded, meaning that it does not meet the IRS's standard for life insurance products aimed at providing a death benefit. When a MEC is created, if a policyholder takes withdrawals or loans against the cash value before death, those amounts are taxed at the policyholder's ordinary income tax rate, rather than the more favorable capital gains rates that generally apply to life insurance policies that are not classified as MECs.

This tax treatment incentivizes policyholders to consider their withdrawal and loan strategies carefully, as it can significantly affect their overall tax liability. While premium payments are not tax-deductible, and policy loans are allowable (albeit with tax implications if it’s a MEC), the correct answer highlights the immediate tax impact individuals may face with distributions, exposing them to ordinary income tax on the amounts withdrawn or borrowed.