A policyowner takes a cash withdrawal from a non-MEC life insurance policy that exceeds the total premiums paid into the policy. The excess amount withdrawn is:

Why A is correct

Under IRC Section 72(e), amounts withdrawn from a life insurance policy's cash value are taxable to the extent they exceed the policyowner's cost basis, generally the total premiums paid. Under the cost recovery method, withdrawals first return the basis tax-free; once basis is fully recovered, further withdrawals are taxable as ordinary income. A policy loan, by contrast, is a borrowing and is not a taxable distribution. If the policy is a MEC, withdrawals are taxed on a LIFO basis with a possible 10% penalty before age 59 and a half.

Why the other options are wrong

• B) Life insurance cash value withdrawals are not always tax-free; the gain over the cost basis is taxable ordinary income. Once the basis is recovered, further withdrawals become taxable, so the blanket statement is wrong.
• C) Withdrawals are not a sale of an asset, so they are ordinary income, not capital gain, when they exceed the basis. Withdrawals above basis are ordinary income because they are not a sale of the policy.
• D) Using withdrawn funds to buy another policy does not make the withdrawal tax-free; that function is performed by a Section 1035 exchange. Only a Section 1035 exchange preserves tax deferral for the transferred contract, not a direct withdrawal.

Memory hook

Pull out more than you put in, and the IRS pulls that extra into income.