Withdrawal Before an Exchange and a Loan from a MEC Whole Life Policy
Elena, age 66 and still working, owns a nonqualified deferred variable annuity bought 12 years ago with a $180,000 single premium; it is now worth $260,000 and she has never taken a withdrawal. She wants to withdraw $40,000 to pay off credit-card debt, then 1035 exchange the remaining balance into a new variable annuity with a 7-year surrender charge and a 2% market value adjustment, adding a guaranteed lifetime withdrawal benefit for a 3.1% annual fee. Separately, she owns a whole life policy that an agent overfunded; the insurer notified her in 2021 that it is a modified endowment contract. Its cash value is $90,000 and she has paid $55,000 in premiums. She wants to borrow $25,000 from it for a kitchen renovation and repay it over five years. She asks whether either move creates a tax bill and whether she should do the withdrawal before or after the exchange.
1. Explain the tax result of the $40,000 annuity withdrawal, including basis and the 10% additional tax, and whether the order of the withdrawal and the 1035 exchange matters.
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Nonqualified annuity withdrawals are taxed LIFO: the $40,000 comes out of the $80,000 of gain first, so the full $40,000 is ordinary income and her $180,000 basis is untouched. The 10% additional tax under IRC 72(q) does not apply because she is past 59 1/2, so age, not an exception, is doing the work here. Order matters for two reasons. Taking the money from the old contract first avoids the new contract's seven-year surrender charge and market value adjustment on the withdrawal, and it fixes the tax at today's rates rather than deferring it. Doing the 1035 exchange first is still tax-free under Section 1035, and the basis carries over, but a subsequent $40,000 withdrawal would be LIFO from the new contract and could trigger surrender charges and an MVA. Either way, the gain is recognized; the timing decision is about surrender charges and rate exposure, not about avoiding tax.
2. Explain the tax treatment of the $25,000 MEC loan and whether repayment fixes it. What if she surrenders instead?
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A loan from a modified endowment contract is treated as a distribution under IRC 72(e)(10), not as borrowed money. With $90,000 of cash value and $55,000 of basis, the contract has $35,000 of gain, so the $25,000 loan is fully taxable as ordinary income. The 10% additional tax under 72(v) applies to MEC distributions before age 59 1/2, so at 66 she avoids it. Repayment does not reverse the recognition event; it restores the contract's economics, and the amount included in income generally increases her investment in the contract so the same dollars are not taxed twice later. That basis tracking is why documentation matters. If she surrenders instead, she recognizes the full $35,000 of gain in one year, again without the 10% penalty because of her age, but she loses the coverage. She should also know that a MEC can be exchanged under 1035 only into another MEC-type contract, such as an annuity, not into a non-MEC life policy.
3. If she instead annuitizes the new annuity at 70 with a $300,000 value and $180,000 basis over a 20-year period certain, how is each payment taxed?
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Use the exclusion ratio: investment in the contract divided by expected return. Suppose the contract pays $1,850 per month, or $22,200 per year, for 20 years; expected return is $444,000. The exclusion ratio is $180,000 divided by $444,000, about 40.5%. Roughly $8,990 of each year's payments is a tax-free return of basis and about $13,210 is ordinary income. Because the payout is period-certain rather than a life annuity, the basis is fully recovered over the 20 years, after which every payment is taxable if payments continue. She must also account for the new contract's rider fee and expenses before comparing any payout quote, and she should compare annuitizing against the lifetime withdrawal benefit, since electing the rider and then annuitizing may forfeit or duplicate benefits. The exclusion ratio is fixed at the annuity starting date and does not change with market performance.