Which of the following statements about Modified Endowment Contracts (MECs) is INCORRECT?

Which of the following statements about Modified Endowment Contracts (MECs) is INCORRECT?

• A. An MEC must always pass the 7-pay test
• B. Policy loans from an MEC are tax-free
• C. Withdrawals will incur a 10% penalty if taken before age 59½
• D. MECs may limit the cash value growth

Answer: (B)

The reasoning behind identifying that policy loans from a Modified Endowment Contract (MEC) are tax-free is misleading. In reality, while loans taken from a MEC can be received without immediate tax liability, they are not entirely tax-free in all circumstances. If the policy lapses, or if the policy is surrendered, or if distributions exceed premiums paid, tax may be owed on the gains. In contrast, the other statements regarding MECs provide accurate insights into their characteristics. For instance, MECs must indeed pass the 7-pay test, which is a measure to ensure the policy does not accumulate cash value too quickly compared to the base death benefit. Additionally, while withdrawals taken before age 59½ may incur a 10% penalty, this is consistent with IRS regulations regarding early distributions. Moreover, it is true that MECs may limit cash value growth due to their design and the regulatory framework surrounding them. Thus, while loans might avoid immediate taxation, it's essential to understand the conditions under which tax implications might arise, making the statement about policy loans from an MEC misleading.

The reasoning behind identifying that policy loans from a Modified Endowment Contract (MEC) are tax-free is misleading. In reality, while loans taken from a MEC can be received without immediate tax liability, they are not entirely tax-free in all circumstances. If the policy lapses, or if the policy is surrendered, or if distributions exceed premiums paid, tax may be owed on the gains.

In contrast, the other statements regarding MECs provide accurate insights into their characteristics. For instance, MECs must indeed pass the 7-pay test, which is a measure to ensure the policy does not accumulate cash value too quickly compared to the base death benefit. Additionally, while withdrawals taken before age 59½ may incur a 10% penalty, this is consistent with IRS regulations regarding early distributions. Moreover, it is true that MECs may limit cash value growth due to their design and the regulatory framework surrounding them.

Thus, while loans might avoid immediate taxation, it's essential to understand the conditions under which tax implications might arise, making the statement about policy loans from an MEC misleading.