What tax treatment applies to distributions from a Modified Endowment Contract (MEC)?

Distributions from a Modified Endowment Contract (MEC) are subject to Last-in, first-out (LIFO) tax treatment. This means that any distribution will be treated as coming from the most recently paid premiums or earnings first before returning any of the premium contributions.

For MECs, any gains or earnings from the policy are taxed as ordinary income upon withdrawal. Thus, when a policyholder takes a distribution, the earnings (considered the last to be paid in) are withdrawn first and taxed accordingly. This is contrary to the treatment of traditional life insurance policies, which typically use a FIFO approach, allowing policyholders to withdraw their contributions (premiums) tax-free until they reach the gains.

Understanding this tax treatment is crucial for policyholders to manage the tax consequences of their distributions effectively.