Which statement correctly compares how a partial withdrawal from a non-MEC life insurance policy is taxed versus a partial withdrawal from a nonqualified annuity?
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Answer & full 3-part explanation (select an option above, or peek)
Why C is correct
IRC §72(e) draws a critical distinction between the two contracts. Withdrawals from a non-MEC life insurance policy are treated as a recovery of basis first (FIFO), so gain is recognized only after the cost basis is exhausted. Withdrawals from a nonqualified deferred annuity are treated as gain first (LIFO), so any withdrawal is taxable as ordinary income up to the accumulated gain before basis is recovered. The same gain-first rule applies to MEC distributions. Understanding this contrast is essential for recommending which product a client should access first and for predicting the tax result of a partial withdrawal.
Why the other options are wrong
- A) Only annuities and MECs use gain-first LIFO; a non-MEC life policy uses basis-first FIFO, so the two contracts are not taxed the same way. The answer must distinguish the two contracts.
- B) The comparison is reversed: life insurance recovers the owner's basis first, while annuity withdrawals are taxed as gain first under the LIFO rule. This statement reverses the true ordering.
- D) Both are not FIFO; the annuity is taxed gain-first under the LIFO rule, which is the opposite ordering from the life policy. The annuity cannot be taxed as FIFO.
Memory hook
Life is FIFO, annuity is LIFO — life returns your premium before taxing, annuities tax gains first.