Question

Peter, age 42, surrendered his modified endowment contract for which he paid $30,000 in total net premiums. If his cash value was $40,000 at the time of the surrender and no exception to the tax penalty applies, what tax penalty was imposed?

1. $0
2. $1,000
3. $100
4. $500

Answer 1

To determine the tax penalty for Peter on the surrender of his modified endowment contract (MEC), we first need to calculate the gain on the contract.

1. **Total premiums paid**: $30,000
2. **Cash value at surrender**: $40,000

The gain on the contract is calculated as follows:

\[
\text{Gain} = \text{Cash value} - \text{Total premiums paid}
\]
\[
\text{Gain} = 40,000 - 30,000 = 10,000
\]

Since this is a modified endowment contract, any gain that is withdrawn as cash is subject to income tax. Additionally, if a MEC is surrendered or a loan is taken out, a penalty tax of 10% may be applied to the taxable amount if the contract owner is under the age of 59½.

In this case, Peter is 42 years old and does not meet the age exception. The taxable portion of the distribution is the gain, which is $10,000.

The tax penalty imposed is calculated as 10% of the gain:

\[
\text{Tax penalty} = 10\% \times \text{Gain} = 0.10 \times 10,000 = 1,000
\]

Therefore, the tax penalty imposed on Peter for surrendering his modified endowment contract is **$1,000**.

The correct answer is:

**2. $1,000**