CFP Board Practice Exam Question 15

A 60-year-old client owns a life insurance policy that is classified as a modified endowment contract (MEC). The client has taken out a policy loan of $300,000. The basis in the contract is $400,000 and the policy cash value is $600,000. What is the taxable income, if any, from the policy loan?

A. $0

B. $100,000

C. $200,000

D. $300,000

Key: C

Rationale:

A. Incorrect. Policy loans from modified endowment contract (MEC) policies are subject to income taxation to the extent of any gain in the contract.

B. Incorrect. This is the amount by which the basis exceeds the policy loan amount which is irrelevant in calculating the gain in the contract.

C. Correct. The gain in the contract is $200,000 ($600,000 - $400,000) and is the portion of the loan treated as taxable income. The tax treatment is last-in/first-out (LIFO) for MEC policies.

D. Incorrect. This is the full amount of the loan which exceeds the gain in the contract.