Maryland Life and Health Insurance License Practice Exam

Which of these benefits is NOT subject to income taxation under a Modified Endowment Contract (MEC)?

1. Death benefit

2. Cash value growth

3. Policy loans

4. Withdrawals

The correct answer is: Death benefit

The death benefit of a Modified Endowment Contract (MEC) is generally not subject to income taxation. This means that when a policyholder passes away, the beneficiaries receive the death benefit free from income tax, which is a key advantage of life insurance policies. This tax treatment applies regardless of whether the policy is classified as a MEC or a standard life insurance policy. The rationale is to provide financial protection to beneficiaries during a time of loss without adding additional financial burdens due to taxes. In contrast, the other options involve benefits that may trigger tax consequences. For instance, cash value growth in a MEC may be subject to taxation if the policy is surrendered or if loans are taken against it. Policy loans can create an income tax liability if the policy lapses or is surrendered with an outstanding loan balance. Withdrawals may be taxable to the extent that they exceed the policy's cost basis, which is the amount paid into the policy. Thus, understanding the taxation implications of each option is crucial for someone owning or considering a MEC.