Certified Financial Consultant (CFC) Practice Exam

What is FALSE about the taxation of Modified Endowment Contracts?

1. Withdrawals are not taxable.

2. Distributions before age 59 1/2 incur a 10% penalty on policy gains.

3. Policy loans are taxable distributions.

4. Accumulations are tax deferred.

The correct answer is: Withdrawals are not taxable.

Withdrawals from Modified Endowment Contracts (MECs) are subject to taxation, specifically, they are taxed on the gains before the basis is returned. The tax treatment of withdrawals from a MEC is akin to that of other life insurance policies, where the principal can often be withdrawn tax-free, but any gains are taxable. Therefore, stating that withdrawals are not taxable is incorrect. On the other hand, the other statements accurately reflect the taxation rules surrounding MECs. Distributions before age 59 1/2 do incur a 10% early withdrawal penalty on any policy gains, making it a critical factor for those withdrawing funds prematurely. Additionally, policy loans taken against the cash value of a MEC are considered taxable distributions to the extent that they exceed the policy's basis, which means that such loans can carry tax implications. Lastly, the accumulations within a MEC grow on a tax-deferred basis, meaning policyholders do not owe taxes on the interest or gains as they accumulate inside the policy. This illustrates the fundamental aspects of how MECs are treated for taxation purposes, and it highlights the accuracy of the other statements in the question.