California Life & Health: Federal Tax Considerations — Life & Annuities

Correct

The answer is A: Policy loans from a non-MEC are not taxable as long as the policy remains in force.

A policy loan from a non-MEC life insurance policy is treated as a loan against the cash value, not as a distribution, so it is not taxable income while the policy stays in force (IRC §72(e)(5)). If the policy later lapses or is surrendered with the loan outstanding, the loan is treated as an amount received and any excess over the owner's cost basis becomes taxable. There is no one-year repayment rule, and the 10% additional tax before age 59½ applies to taxable MEC distributions and loans, not to a loan from a non-MEC policy.

Reviewed in our October 2026 California fact-check.

Correct

The answer is D: The premiums paid into the policy, reduced by any dividends or withdrawals received tax-free.

For federal income tax purposes, a policy's cost basis (the investment in the contract) is the premiums paid, less amounts already received tax-free, such as dividends and withdrawals up to basis (IRC §72(e)(6)). It is the owner's own after-tax money in the contract, and it is what comes back tax-free; on surrender, only the amount above basis is taxed. Cash surrender value, the death benefit, and the face amount plus interest are other policy values, not the basis.

Reviewed in our October 2026 California fact-check.

Correct

The answer is C: It is not taxable, as a return of cost basis (FIFO).

For a non-MEC life insurance policy, withdrawals are taxed on a First-In, First-Out (FIFO) basis: the cost basis comes out first, tax-free (IRC §72(e)(5)). The $10,000 withdrawal is less than the $15,000 basis, so it is a tax-free return of premium. The policy's age matters because a withdrawal accompanied by a death benefit reduction in the first 15 years can be taxed under a special rule, and this policy is past that period. The 10% additional tax belongs to MEC distributions, and gain withdrawn from a policy is ordinary income, not capital gain.

Reviewed in our October 2026 California fact-check.

Correct

The answer is D: The gain (value minus cost basis) is taxable as ordinary income.

Unlike life insurance death proceeds, a nonqualified annuity's death benefit is not income-tax-free. The beneficiary owes ordinary income tax on the gain, meaning the amount received over the owner's cost basis. The basis comes back tax-free. There is no step-up in basis at death, and the gain is ordinary income, not capital gain. That the contract was nonqualified only means the premiums were paid with after-tax money, which protects the basis and nothing more.

Reviewed in our October 2026 California fact-check.

Correct

The answer is B: The proceeds are generally income-tax-free.

Life insurance death benefits paid in a lump sum are generally income-tax-free to the beneficiary under federal tax law.

Reviewed in our October 2026 California fact-check.