What kind of tax is generally imposed on the gain from a modified endowment contract?

A modified endowment contract (MEC) is a type of life insurance policy that has been funded with premiums that exceed federally defined limits. When gains are withdrawn from a MEC, they are treated differently for tax purposes compared to traditional life insurance contracts. The tax implications are significant because the gains are considered taxable as income.

When a policyholder cashes in the gains from a MEC, the Internal Revenue Service (IRS) requires that these gains are subject to income tax. This means that any money withdrawn above the amount invested into the contract (the basis) will be taxed as ordinary income, rather than benefiting from capital gains rates, which can be lower. This treatment underscores the essential point that the tax on the earnings accrued in a MEC is treated as regular income rather than just a capital gain.

Other forms of tax like sales tax or property tax do not apply in this context, as they are unrelated to the income derived from insurance products. Understanding the tax implications of MECs is crucial for effective financial planning and tax strategy.