How is the gain treated for federal income taxes when a modified endowment contract (MEC) is surrendered?

When a modified endowment contract (MEC) is surrendered, any gain that has accrued in the contract is treated as taxable income. This means that the policyholder must report the gain as ordinary income on their federal tax return. Furthermore, because MECs do not fall under the same tax-deferred treatment as other life insurance contracts, early withdrawals or surrenders can also incur additional penalties if the policyholder is under the age of 59½. The penalty is typically an additional 10% tax on the taxable amount, reflecting the IRS's intention to discourage early withdrawals from these types of contracts.

This treatment differs from that of traditional life insurance policies where cash values can generally be accessed without immediate tax consequences. The other options suggest scenarios that do not align with the tax treatment of MECs under federal law. For instance, claiming that the gain is tax-exempt or not taxable until withdrawn overlooks the reality of how gains in MECs are taxed upon surrender. Also, stating that the gain is subject to reduced tax rates does not account for the treatment of these gains as ordinary income. Understanding the tax implications of MECs is crucial for policyholders to make informed financial decisions.