A client pays $100,000 in a single lump sum to fund a whole life policy. The IRS determines the policy fails the 7-pay test. Which tax consequence applies to cash value withdrawals during the insured's lifetime?

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Gain is taxed first as ordinary income, plus a 10% penalty before age 59½ — A single-premium life policy almost always fails the IRS 7-pay test and is therefore classified as a Modified Endowment Contract (MEC). The MEC classification does not affect the death benefit (still income-tax-free to beneficiaries) but dramatically changes the tax treatment of lifetime distributions: withdrawals and loans are taxed on a LIFO (last-in, first-out) basis, meaning gain comes out first as ordinary income. Additionally, if the policyowner is under age 59.5, a 10% early-distribution penalty applies to the taxable portion — mirroring the penalty that applies to IRA and annuity early withdrawals. Non-MEC life policies use FIFO treatment (basis out first, tax-free). See TX Outline §IV.G.

A client pays $100,000 in a single lump sum to fund a whole life policy. The IRS determines the policy fails the 7-pay test. Which tax consequence applies to cash value withdrawals during the insured's lifetime?

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