When an individual surrenders their modified endowment contract, what financial consequence may they face?

When an individual surrenders a modified endowment contract (MEC), they may face significant financial consequences, one of which is the possibility of penalties. Modified endowment contracts are life insurance contracts that fail to meet the 7-pay test, which means they have exceeded certain premium limits within the first seven years.

As a result of this classification, any withdrawals or surrenders from the contract are subject to tax penalties. This includes taxation on any earnings, which are taxed as ordinary income, along with an additional 10% penalty if the individual is under age 59½ at the time of withdrawal. The intention of these penalties is to discourage policyholders from treating their life insurance as an investment vehicle rather than a means of providing a death benefit.

Moreover, surrendering an MEC can result in the loss of the death benefit associated with the policy. Therefore, the financial implications of surrendering such a contract can be significant, making the understanding of penalties essential for policyholders considering this action.