Advanced Underwriting Consultants

Question of the Day – November 6

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question:  My 40 year old client is purchasing a life contract that will be a modified endowment contract (MEC).  Can she avoid the penalty tax on distributions by using the Section 72(q) exception?

Answer:  Yes.

Distributions from a non-MEC life contract are considered a tax-free return of basis first, and taxable thereafter.  Distributions from a MEC are taxed on a gain-first basis, and the taxable portion of distributions is also potentially subject to a 10% penalty tax.

Revenue Code Section 72 says that lifetime distributions from a MEC life policy are taxed the same way as lifetime distributions from a non-qualified annuity (NQDA).  Taxable distributions from an NQDA are subject to the 10% penalty tax, unless one of the exceptions of Code Section 72(q) applies.

Section 72(q) makes an exception for the 10% penalty tax where the annuity payments are

part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and his designated beneficiary.

The exception is substantially identical to the Section 72(t) exception to the penalty tax for IRA or qualified plan distributions.

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