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). The statement that the death benefit becomes fully taxable to the beneficiary is incorrect — the death benefit retains its income-tax-free treatment. The statement that premiums become deductible as an itemized medical deduction is wrong — life insurance premiums are never deductible by an individual policyowner. And the statement that the policy loses life insurance status and is taxed as an annuity conflates §7702A (MEC rules) with §7702 (definition of life insurance) — a MEC remains life insurance for §7702 purposes; only the living-benefit taxation changes.