What is the primary risk associated with a Modified Endowment Contract?

The primary risk associated with a Modified Endowment Contract (MEC) is the 10% withdrawal penalty before age 59.5. A MEC is a type of life insurance policy that has been classified as a MEC due to the way it is funded, often through excessive premium payments within a short time frame. This classification results in the policy losing some of the favorable tax treatment typically enjoyed by life insurance policies.

When an insurance policy is classified as a MEC, any withdrawals or loans taken from the cash value before the policyholder reaches the age of 59.5 are subject to a 10% penalty tax on the taxable portion of the distribution. This means that not only are the funds subject to ordinary income tax, but there is also an added layer of penalty tax for early withdrawals. This aspect significantly alters the financial considerations for policyholders, influencing their decisions about accessing funds from their policy. Understanding this penalty is crucial for individuals considering a MEC, as it can impact their long-term financial planning strategies.