What happens to a life insurance policy when a person surrenders their modified endowment contract?

When a policyholder surrenders a modified endowment contract (MEC), they trigger a tax event that is considered a distribution of funds. Because a MEC is classified under the Internal Revenue Code as a life insurance policy that has exceeded certain premium limits, any gain that has accumulated in the policy becomes subject to taxation when the policy is surrendered. The gain refers to the amount that is above what the policyholder has paid in premiums.

Therefore, the policyholder will need to pay taxes on any gains realized at the time of surrender. This taxation occurs because the IRS treats distributions from MECs differently compared to traditional life insurance policies, where the cash value can generally grow without immediate tax implications. In essence, surrendering a MEC means acknowledging the growth may be taxable, which is a significant consideration for policyholders contemplating surrendering their policy.

In contrast, reinstatement or indefinite continuation of the policy does not apply upon surrender, nor do dividends become relevant in this transaction, as it's primarily concerning the tax implications of surrendering the contract.