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Question: My client owns a life insurance policy that is a modified endowment contract (MEC).  If the client uses the policy as collateral for a bank loan, will the amount of the loan be potentially taxable to the client?

Answer: Yes.

Code Section 72(e) provides the following rule that applies to MEC contracts and nonqualified annuities:

        (A) Loans treated as distributions

          If, during any taxable year, an individual -

            (i) receives (directly or indirectly) any amount as a loan

          under any contract to which this subsection applies, or

            (ii) assigns or pledges (or agrees to assign or pledge) any

          portion of the value of any such contract,

        such amount or portion shall be treated as received under the

        contract as an amount not received as an annuity.  

For a MEC contract, an amount not received as an annuity is taxable to the extent there is gain in the contract.  If the policy owner is younger than 59 ½, the gain portion is also subject to the 10% penalty tax.

If the loan balance grows and the policy continues to collateralize the loan balance, the incremental annual increases in loan value are also potentially taxable distributions.

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