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Question: My client owns a MEC life insurance policy that she wants to exchange for an immediate annuity. What are the tax consequences of doing so?
Answer: The exchange of a life contract for an annuity is tax-free under Code Section 1035. That’s true whether it’s a “regular” life contract being traded for an annuity or a MEC that’s being traded.
If a MEC is traded for a SPIA, there’s no tax recognition at the time of transfer. Each of the SPIA payments will each be partly a recovery of basis (based on the basis from the MEC life policy) and partly ordinary income.
The ordinary income portion of the payments will also be subject to the 10% penalty tax if the taxpayer is younger than 59 ½ and if the SPIA payout period is for a duration shorter than the taxpayer’s life expectancy.
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