MEC & Life Insurance Taxation on the CA 2-15 Exam

The default: life insurance is tax-favored

Start from the baseline the exam assumes: death benefits paid in a lump sum to a named beneficiary are income-tax free. Cash value grows tax-deferred — nobody pays tax while it accumulates. Policy loans are not taxable income, because a loan is debt, not a distribution.

Withdrawals from a normal (non-MEC) policy use FIFO — "first in, first out". Your own premium dollars (the cost basis) come out first, tax-free; only gains above basis are taxable. Dividends from participating policies are treated as a return of overcharged premium — not taxable (though interest earned on dividends left with the insurer is).

• Lump-sum death benefit → income-tax free to the beneficiary
• Death benefit taken in installments → the interest portion is taxable
• Cash value growth → tax-deferred; taxed only on surrender, and only the gain above basis
• Premiums for personal life insurance → NOT tax-deductible

MEC: what happens when a policy is overfunded

Congress noticed people stuffing money into life policies purely as tax shelters, so TAMRA (1988) drew a line: a policy funded faster than the 7-pay test allows becomes a Modified Endowment Contract. The 7-pay test asks: did the owner pay in more during the first 7 years than the level premiums that would have paid the policy up in 7 years?

Fail the test and the policy is a MEC forever — it can never regain normal tax treatment. It is still life insurance, and its death benefit is still income-tax free. What changes is how money comes OUT while the insured is alive.

• Distributions from a MEC use LIFO — gains come out first, and gains are taxable
• Loans and withdrawals from a MEC are BOTH treated as distributions
• A 10% penalty applies to taxable amounts taken before age 59½
• Once a MEC, always a MEC — including any policy received in exchange for a MEC

How the exam words it

Exam questions rarely say "compute the tax". They describe a policyowner action and ask about the consequence. "Sam takes a $10,000 loan from his whole life policy" → not taxable. "Sam takes the same loan from a policy that failed the 7-pay test" → taxable to the extent of gain, plus 10% penalty if Sam is under 59½.

The other repeat customer is the 1035 exchange: life-to-life, life-to-annuity, and annuity-to-annuity swaps are tax-free; annuity-to-life is not allowed tax-free. If a question mentions replacing one contract with another "without current taxation", it is pointing at Section 1035.