MEC taxation rules are the specific IRS guidelines that govern how distributions from a Modified Endowment Contract are taxed. Once a life insurance policy becomes a MEC-typically by failing the 7-pay test or through certain material changes-its loans and withdrawals are taxed under Section 72 as income-first distributions. Under these rules, any gain in the policy must be withdrawn before the policyowner can recover their tax basis, creating last-in, first-out (LIFO) treatment. Taxable amounts are subject to ordinary income tax rates rather than capital gains rates. In addition, if the policyowner is younger than age 5912 at the time of a taxable distribution, a 10 percent penalty tax may apply unless a limited exception is met. MEC taxation rules also extend to assignments or pledges of the policy as collateral, which can be treated as deemed distributions. Importantly, MEC status cannot be reversed by simply changing premiums or face amount later; once a policy is a MEC, these rules apply for the life of that contract.

In day-to-day practice, MEC taxation rules are referenced whenever an advisor, CPA, or attorney is evaluating whether policy loans or withdrawals are appropriate for a client with a MEC. Home-office illustration teams often include MEC tax summaries on inforce ledgers so producers can see what portion of potential distributions would be taxable under LIFO rules. When designing premium-financed or max-funded policies, advanced markets departments frequently warn that crossing MEC limits means MEC taxation rules will govern all future distributions, which may conflict with a client's desire for tax-efficient supplemental income. During suitability and disclosure conversations, producers should clearly describe MEC taxation rules, document that the client understands income-first treatment and potential penalties, and obtain signed acknowledgments where required. Compliance teams may also flag recommendations that involve accessing MEC cash values without a clear explanation of how MEC taxation rules affect the client's after-tax results.