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.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – November 28

Ask the Experts!

Here’s the question of the day.

Question: My client owns a life insurance policy that is a modified endowment contract (MEC).  If the client uses the policy as collateral for a bank loan, will the amount of the loan be potentially taxable to the client?

Answer: Yes.

Code Section 72(e) provides the following rule that applies to MEC contracts and nonqualified annuities:

        (A) Loans treated as distributions
          If, during any taxable year, an individual -
            (i) receives (directly or indirectly) any amount as a loan
          under any contract to which this subsection applies, or
            (ii) assigns or pledges (or agrees to assign or pledge) any
          portion of the value of any such contract,
        such amount or portion shall be treated as received under the
        contract as an amount not received as an annuity. 

For a MEC contract, an amount not received as an annuity is taxable to the extent there is gain in the contract.  If the policy owner is younger than 59 ½, the gain portion is also subject to the 10% penalty tax.

If the loan balance grows and the policy continues to collateralize the loan balance, the incremental annual increases in loan value are also potentially taxable distributions.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.