What is the primary disadvantage of a Modified Endowment Contract (MEC)?

A Modified Endowment Contract (MEC) refers to a specific type of life insurance policy that does not meet the IRS's seven-pay test, which determines whether the funding of a life insurance policy is considered as excessive. The primary disadvantage of a MEC is the loss of tax advantages associated with life insurance.

When a policy is classified as a MEC, it loses the favorable tax treatment that typically applies to life insurance policies. For instance, the cash value within a MEC grows on a tax-deferred basis; however, when withdrawals or loans are taken against this cash value, they may be subject to income tax, as well as a potential 10% penalty if the policyholder is under 59½ years old. This contrasts with non-MEC policies, where loans and withdrawals can be taken without immediate tax implications.

Understanding this fundamental difference in tax treatment helps clarify why it is important for policyholders to be aware of how their insurance funding can affect their financial strategy, especially regarding cash value and long-term benefits. The other options, while they may represent various concerns related to life insurance policies, do not capture the essence of the primary drawback of MECs in terms of taxation and cash value access.