A policyowner takes a partial withdrawal from the cash value of a permanent life policy. The total premiums paid exceed the amount withdrawn. For income tax purposes, the withdrawal is:

Why A is correct

Under IRC Section 72, money withdrawn from a policy's cash value is first treated as a return of the policyowner's cost basis, the premiums paid, and is therefore nontaxable up to that basis. Only withdrawals in excess of the cost basis represent taxable gain and are included in income. The 10% penalty generally applies only to distributions from modified endowment contracts (MECs) taken before age 59 1/2; an ordinary life insurance policy is not subject to that penalty.

Why the other options are wrong

• B) Only the amount in excess of basis is taxable; the basis portion is a return of premium.
• C) The 10% penalty applies to early MEC distributions, not to ordinary policy withdrawals.
• D) Withdrawals from cash value are ordinary income, not capital gain.

Memory hook

Cash withdrawals are tax-free up to what you paid in; only the profits are taxed.