California Life and Health Insurance Practice Exam

What is the percentage of the penalty tax for premature withdrawals in a modified endowment contract?

1. 5%

2. 10%

3. 15%

4. 20%

The correct answer is: 10%

In the context of modified endowment contracts (MECs), the percentage of the penalty tax for premature withdrawals is set at 10%. This is particularly relevant because MECs are subject to strict IRS guidelines that govern how much can be contributed and how withdrawals are taxed. If a policyholder takes a withdrawal or loan from a MEC before reaching the age of 59½, they incur a 10% penalty tax on the amount taken. This penalty is designed to discourage the use of life insurance policies as short-term investment vehicles and to ensure compliance with the intended long-term savings purpose of the policy. Understanding this penalty helps policyholders make informed decisions regarding their insurance and investment choices, as the tax implications can significantly affect the overall value of the contract. Other penalty percentages, such as 5%, 15%, or 20%, do not apply in this specific scenario and are not applicable to MECs under current tax regulations.