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A 45-year-old owner withdraws $20,000 from a MEC with $50,000 of cash value and $30,000 of basis. Under IRC §72(e) and §72(v), the federal income-tax treatment of the withdrawal is:

AAll $20,000 is recovery of basis (FIFO); no income tax and no penalty
B$12,000 is taxable gain pro rata and $8,000 is basis; no penalty applies because withdrawals are not 'distributions'
COnly $10,000 is taxable as gain and no penalty applies because the policy is more than 5 years old
All $20,000 is taxable gain (LIFO) plus a 10% additional tax of $2,000 under §72(v)

Why this is the answer

Non-MEC permanent life insurance enjoys FIFO basis recovery on withdrawals and loan-based access to cash value. A MEC reverses both: (1) §72(e)(10) imposes LIFO (income-first) ordering, so withdrawals are taxable to the extent of policy gain before any basis is recovered, and (2) loans, partial withdrawals, and assignments are all treated as 'amounts received' and taxed the same way. §72(v) adds a 10% additional tax on the includible portion when the owner is under age 59½ (subject to exceptions for disability and substantially equal periodic payments). Here, gain ($20K) ≥ withdrawal, so the entire $20K is ordinary income plus $2,000 penalty.

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