How is the gain from a surrendered modified endowment contract treated for federal income tax purposes?

When a modified endowment contract (MEC) is surrendered, the gain from that surrender is treated as taxable income for federal income tax purposes. The significant aspect of a modified endowment contract is that it does not follow the same tax treatment as traditional life insurance policies due to its funding levels.

Specifically, when an MEC is surrendered, any gain — which is defined as the amount received over the investment in the contract — is included in gross income. Furthermore, if the policyholder is under the age of 59½, there is an additional 10% penalty tax on that gain. This treatment exists to discourage the use of life insurance policies as short-term investment vehicles rather than for the purpose of providing a death benefit.

This specific approach to taxation is important for policyholders to understand, as it can significantly impact their financial decisions related to the surrender of such contracts. The tax rules surrounding MECs are designed to ensure they are used primarily for life insurance and not as tax-advantaged savings accounts.