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 – April 30

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: I’ve heard that a withdrawal from cash value life insurance during in the first 15 years of the policy may be subject to taxation.  If the withdrawal reduces policy death benefit but does not exceed cost basis, is it still possible that it may be subject to tax?

Answer: Under normal, non-MEC life insurance taxation rules, withdrawals from a universal life policy are generally treated as a tax-free recovery of basis, and taxable only after all basis has been recovered.

In relatively rare situations, a withdrawal may be taxed differently.  A withdrawal reduces the policy’s death benefit.  Death benefit reductions within the first 15 years of the policy may cause a taxable distribution to be “forced out” of the policy.  The force out is required because of federal rules regarding maximum premiums allowed to be paid into life insurance policies.  Force outs are taxed on a gain-first basis.

A force out is likeliest to happen if the policy has been stuffed full of premium close to the maximum federal guideline limit.

It is difficult or impossible for a non-actuary to be able to predict accurately when a force out may occur, or how much the force out needs to be.  The best advice is to ask prior to taking a distribution or making a policy change during the first 15 years.

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.