Your client holds whole life, group term, and universal life, and has no idea whether a cash value withdrawal triggers tax. That answer changes entirely based on one word: MEC (modified endowment contract).
Term life provides a death benefit for a set period with no cash value. If death occurs during the term, the beneficiary collects income-tax-free. If the insured survives, coverage expires worthless.
Three term forms appear on the exam:
- Level term: fixed premium and death benefit for 10, 15, 20, or 30 years. The workhorse for young families with temporary needs.
- Annual renewable term (ART): one-year policy that renews without proof of health, but the premium rises each year. Use as a short-term bridge, not a long-term plan.
- Decreasing term: level premium, declining death benefit. Designed to mirror a shrinking debt like a mortgage.
KEY: The convertibility rider lets you convert term to permanent without proving health. Conversion locks in the original health class, but the new premium is based on attained age at conversion, not the original issue age.
Common mistakes
- Applying FIFO when the policy is a MEC. Single large premium, limited-pay funding, or the question explicitly stating MEC status all require LIFO. A related error: forgetting that MEC loans are also taxable under LIFO. Trap: "The $30,000 loan from the MEC policy has no tax consequence", wrong.
- Forgetting the $50,000 exclusion on Section 79. Calculating imputed income on the full $250,000 of group coverage instead of the $200,000 excess produces a wrong answer the exam offers as a distractor. Trap value: 250 x $0.23 x 12 = $690 (wrong) vs. 200 x $0.23 x 12 = $552 (correct).
- Confusing who bears investment risk. Whole life = insurer. UL = insurer (credit rate) but policyholder bears lapse risk. VUL = policyholder through subaccounts. IUL = shared via floor and cap.
Bottom line
- Non-MEC = FIFO (basis out first, tax-free; loans non-taxable); MEC = LIFO (gain first, taxable, loans also taxable, plus 10% penalty before 59½)
- Section 79 imputed income: (coverage minus $50,000) / $1,000 x Table I rate x 12
- Death benefits are income-tax-free under IRC 101(a) regardless of MEC status; cash value grows tax-deferred
- Convertibility rider preserves original health class but premium is based on attained age, not issue age
Exam shortcut
First question on any cash-value withdrawal: is it a MEC? Single large premium or limited-pay = MEC = LIFO. No signals = non-MEC = FIFO. For Section 79, always subtract $50,000 before Table I. For 1035 exchanges: life-to-life or life-to-annuity only, annuity-to-life is prohibited.
The full lesson (about 2,754 words, 18 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- C.23
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