A whole life policy fails the 7-pay test and is classified as a Modified Endowment Contract (MEC). Which statement BEST describes the tax consequence to the policyowner?
Explanation
A Modified Endowment Contract under IRC §7702A is still a life insurance contract — the death benefit remains income-tax-free to the beneficiary under IRC §101(a). However, all living distributions (policy loans, partial withdrawals, collateral assignments) are taxed on a LIFO (last-in, first-out) basis: gain comes out first as ordinary income, and a 10% additional tax applies before age 59½ under IRC §72(v). Option A is incorrect — the death benefit retains its income-tax-free treatment. Option B is wrong — life insurance premiums are never deductible by an individual policyowner. Option D conflates §7702A (MEC rules) with §7702 (definition of life insurance) — a MEC remains life insurance for §7702 purposes; only the living-benefit taxation changes.
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