California Accident and Sickness Practice Exam

A Modified Endowment Contract (MEC) is primarily characterized by the way it is treated for tax purposes, especially when it comes to the treatment of distributions. One key characteristic of an MEC is that it loses its tax-favored status for withdrawals and loans. This means that any distributions from an MEC are subject to different tax implications compared to a standard life insurance policy.

The classification of a life insurance policy as an MEC occurs if it fails to meet the 7-Pay Test, which is designed to prevent the policy from being overly funded. This test measures the total premiums paid in the first seven years against a set threshold. Once a policy is deemed an MEC, it experiences a shift in how loans and withdrawals are taxed, leading to LIFO treatment, where distributions are deemed to come from earnings before coming from the cost basis.

In regard to the tax treatment of loans and withdrawals, a standard life insurance policy allows for tax-free loans and withdrawals to the extent of the cost basis. However, for an MEC, the loans and withdrawals are subject to taxation on any gains first, meaning they are not considered tax-free up to the policy's cost basis as they would be in a non-MEC policy.

Therefore, option D is not a characteristic