What is the main disadvantage of a Modified Endowment Contract (MEC)?

A Modified Endowment Contract (MEC) specifically refers to a life insurance policy that has been heavily funded in a way that causes it to fail to meet certain IRS guidelines related to the timely payment of premiums. When a policy is labeled as a MEC, it triggers a significant tax consequence regarding cash value loans and withdrawals.

The main disadvantage lies in the tax treatment of funds withdrawn from or borrowed against the policy. Unlike traditional life insurance policies, which often allow tax-free loans and withdrawals up to the basis of the premiums paid, MECs face taxes on earnings first, which means any distributions will be subject to income tax. Moreover, if a withdrawal is taken before the insured reaches age 59½, there could also be a 10% penalty on the gain.

Understanding this distinction is crucial for policyholders as it impacts financial planning and the tax implications of accessing cash within the policy. This contrasting tax treatment is a significant consideration when evaluating funding strategies for life insurance. Other factors, like premium costs or availability, do not directly relate to the unique implications of modified endowment contracts.