Loan Impact on Basis in a Modified Endowment Contract

Course: Insurance Planning
Lesson 15: Income Taxation of Life Insurance
Student Question:
Can you help me better understand the difference between policy basis in a normal policy and policy basis on a modified endowment contract.
From the Coursework:
But for MEC purposes, the basis is increased by any portion of loans that were considered taxable income because of the MEC.”
What does the formula for basis for a MEC policy become?
Instructor Response:
Whenever a policy holder takes a distribution (loan or direct withdrawal) from the cash value of a MEC, income is recognized by the policy holder if there is tax-deferred interest. The amount of income recognized is the lesser of tax-deferred interest or the amount distributed. Recognized income from the distribution adds to the income tax basis of the policy.
Here’s the income tax basis formula for a MEC:
Premiums paid
-dividends received
-previous non-taxable distributions, if any
+income recognized on distributions =
Income Tax Basis
For example, assume the cash value of a MEC is $50,000. Total premiums of $42,500 were paid and $2,500 was received as dividends. Tax-deferred interest was $10,000. If the policy holder takes a loan of $5,000, then $5,000 of tax-deferred interest must be recognized. No previous non-taxable distributions were taken.
Applying the formula to this fact pattern we see that income tax basis is $45,000 calculated as follows.
$42,500 (Premiums paid)
-2,500 (dividends received)
-0 (previous non-taxable distributions)
+5,000 (income recognized on the distribution)
$45,000 (MEC’s income tax basis)