MEC taxation refers to the special federal income tax treatment that applies to distributions from a Modified Endowment Contract, a life insurance policy that fails the IRS 7-pay test or other MEC tests. While death benefits from a MEC generally remain income-tax free under Internal Revenue Code Section 101, loans, withdrawals, and collateral assignments are taxed less favorably than those from non-MEC policies. Under MEC taxation rules, distributions are treated on a last-in, first-out (LIFO) basis, meaning earnings are deemed to come out first and are taxable as ordinary income until all gain has been recognized. In addition, if the policyowner is under age 5912, a 10 percent penalty tax may apply to taxable distributions, similar to early withdrawals from nonqualified annuities. MEC status is generally permanent, even if premiums stop or funding patterns change later. Because of this, MEC taxation becomes a crucial planning factor whenever a policy is designed with heavy early funding or when material changes trigger MEC re-testing during the life of the contract.

Advisors encounter MEC taxation most often when helping clients evaluate whether to intentionally accept MEC status in exchange for rapid cash accumulation or when correcting designs that accidentally created a MEC. In client conversations, MEC taxation is typically explained in simple terms: a MEC can still provide tax-free death benefits, but its access-to-cash rules resemble those of an annuity, with taxable gain coming out before basis and a possible early-withdrawal penalty. During policy reviews, producers may ask carriers for MEC status confirmations and distribution tax summaries before recommending loans or withdrawals. CPA and attorney partners often want to know whether a policy is a MEC before they sign off on estate or business-planning strategies that assume tax-advantaged access to cash values. When a MEC is used intentionally-such as in wealth-transfer designs where the client never anticipates taking policy distributions-MEC taxation becomes less of a concern, but it still needs to be clearly disclosed and documented in the file.