Minnesota Life Insurance License Practice Exam

Which of the following transactions would not be subjected to income tax under a Modified Endowment Contract (MEC)?

1. The death benefit

2. Cash surrender value

3. Interest earnings

4. Paid-up additions

The correct answer is: The death benefit

The death benefit of a life insurance policy classified as a Modified Endowment Contract (MEC) is not subject to income tax. This is a key feature of life insurance, which retains the favorable tax treatment concerning death benefits. When the policyholder passes away, the beneficiaries receive the death benefit as a tax-free payout, regardless of whether the policy is a MEC or a non-MEC. In contrast, other transactions associated with a MEC can trigger tax implications. For example, cash surrender value withdrawals and interest earnings typically incur income tax liabilities, especially if the policyowner accesses these during the lifetime of the policy, as income is recognized to the extent there is gain in the contract. Paid-up additions, while they may provide additional insurance coverage, also can lead to taxation when surrendered or if they generate cash value. This knowledge is critical for understanding how different components of life insurance policies can impact an individual's tax strategy, especially when dealing with MECs.