Under a Modified Endowment Contract, what are the likely tax consequences?

• A. Pre-death distributions will become taxable
• B. Distributions are tax-free
• C. No tax implications until death
• D. All withdrawals taxed at capital gains rate

Answer: (A)

Under a Modified Endowment Contract, withdrawals before death are taxed as ordinary income to the extent the policy has earnings; you recover the investment (premiums) tax-free only after all earnings have been withdrawn. So pre-death distributions aren’t tax-free—they’re taxable up to the policy’s gains, with any remaining amount returning tax-free only to the extent of the premiums paid. The death benefit itself remains generally tax-free to beneficiaries, but that doesn't change the taxation of distributions during the insured’s life. Capital gains rates don’t apply to life insurance distributions, which is why other options don’t fit.