California Life and Health Insurance Practice Exam

What is the tax penalty for taking a loan against a Modified Endowment Contract before age 59 1/2?

1. 5%

2. 10%

3. 15%

4. No penalty

The correct answer is: 10%

Taking a loan against a Modified Endowment Contract (MEC) before the age of 59 1/2 typically incurs a tax penalty of 10% on the amount withdrawn. MECs are life insurance policies that have been funded too quickly with premiums, creating a scenario where the tax advantages normally associated with life insurance are altered. When policyholders take loans from a MEC, it is considered a distribution for tax purposes, and if the policyholder is under the age threshold of 59 1/2, the IRS imposes a penalty on the distribution amount. Moreover, although loans from a life insurance policy are generally not taxable if the policy is not classified as a MEC, the rules change under MEC status. This significant distinction is crucial to understanding why the 10% penalty applies in this situation. Therefore, taking out a loan from a MEC before reaching the specified age can lead to immediate tax consequences that ensure the government recoups some potential tax revenue.