Section 72(e) Tax Rules for Annuities and Life Insurance: MECs and Loans

Section 72(e) tax rules for annuities and life insurance decide when a withdrawal, surrender, loan, or dividend counts as taxable income and when it comes back to you tax-free. The short version: deferred annuities and modified endowment contracts tax your earnings first, so the first dollars out are ordinary income. Standard life insurance policies work in reverse, letting you pull your premiums back tax-free before any gain is taxed. The order matters, and so does what the IRS treats as a distribution in the first place.

What Section 72(e) Actually Covers

Section 72(e) applies to any amount received under an annuity, endowment, or life insurance contract that isn’t a scheduled annuity payment. That sweeps in lump-sum withdrawals, partial and full surrenders, policy loans, pledges of cash value as collateral, and dividends. The statute also reaches anything “in the nature of a dividend or similar distribution,” which catches almost every way an insurer can put money back in your hands short of turning on lifetime income.¹

The Income-First Rule for Annuities and MECs

For deferred annuities and modified endowment contracts, withdrawals before your annuity starting date follow a last-in, first-out order. The IRS treats the first dollars out as earnings, and those earnings are taxed as ordinary income at your marginal federal rate, which in 2026 runs from 10% to 37%.²

The gain equals the contract’s current cash value (before surrender charges) minus your investment in the contract, which is essentially the total premiums paid. Withdrawals up to that gain are fully taxable. Only after you’ve pulled out all the gain do further withdrawals come back as tax-free premium recovery.¹

An example. You paid $100,000 into a deferred annuity now worth $140,000. Your gain is $40,000. Withdraw $25,000 and every dollar is taxable, because you haven’t cleared the gain layer. Take another $25,000 later, and $15,000 of that is taxable (the rest of the gain); the last $10,000 comes back tax-free.

The rule changes after the annuity starting date. A non-annuity distribution taken after payments have begun is fully taxable, with no allocation to your investment, because your premiums are already being recovered through the exclusion ratio built into the regular payments.¹

Basis-First Treatment for Non-MEC Life Insurance

Life insurance policies that haven’t been classified as modified endowment contracts get the opposite treatment under 72(e)(5)(C). Partial withdrawals come out as a return of premiums first, tax-free, and income tax kicks in only after cumulative withdrawals exceed your total cost basis.¹

So a policyholder who has paid $80,000 in premiums into a policy worth $120,000 can pull out up to $80,000 without owing federal income tax. Only amounts above $80,000 are taxable as ordinary income. Withdrawals reduce the policy’s death benefit and cash value, so this flexibility has practical limits.

How a Policy Becomes a MEC and What That Costs

A life insurance policy becomes a modified endowment contract if cumulative premiums in the first seven years exceed what would be needed to pay up the policy with seven level annual premiums. That’s the 7-pay test.³ A policy that fails the test, or fails a recalculated version after a material change, loses the basis-first treatment permanently. There’s no way to undo the classification once it happens.

Section 72(e)(10) pushes MECs back into the income-first rule, so every withdrawal is taxable to the extent of the policy’s gain, and loans against the cash value count as taxable distributions too.¹

Then Section 72(v) adds a 10% additional tax on top of ordinary income tax for the taxable portion of a MEC distribution.¹ The penalty is waived if you’re at least 59½, if the distribution results from a disability, or if it’s part of a series of substantially equal periodic payments over your lifetime.

Loans, Pledges, and the Lapse Trap

Section 72(e)(4)(A) treats loans and collateral pledges against a deferred annuity or MEC as if you had taken a cash withdrawal. The borrowed amount is taxable to the extent of the contract’s gain.¹ After the loan is taxed, your investment in the contract goes up by the same amount so you aren’t taxed on it again later.

Non-MEC life insurance is the exception. Policy loans against a standard life insurance contract remain tax-free, which is one of the main benefits lost when a policy crosses into MEC territory.

The costliest surprise under 72(e) shows up when a policy or annuity with an outstanding loan lapses or is surrendered. The taxable gain is calculated on the full cash value before the loan is repaid, not on the net amount you actually receive. Say you paid $60,000 in premiums, the cash value grew to $105,000, and you had a $90,000 loan outstanding. If the policy lapses, the taxable gain is $45,000 (the $105,000 cash value minus your $60,000 basis). The loan consumes most of the cash value, so you walk away with roughly $15,000 and a tax bill on $45,000. Courts have consistently held that the gain is taxable even when the entire cash value goes to repay the loan and the policyholder receives nothing.

If you carry policy loans, watch the loan-to-value ratio. When premiums stop and the remaining cash value can’t cover loan interest, the insurer terminates the policy, and this trap springs.

Dividends and Partial Surrenders

Insurance dividends are non-annuity amounts under 72(e)(1)(B), but the tax result depends on what happens to them.¹ If the insurer keeps the dividend as a premium payment or applies it to buy paid-up additions, 72(e)(4)(B) leaves it out of gross income. Taken in cash, a dividend reduces your cost basis. Once cumulative cash dividends exceed the premiums you’ve paid, any further cash dividend is taxable as ordinary income. The same logic applies to dividends used to pay down a policy loan.

Partial surrenders follow whichever rule governs the contract. From a non-MEC life policy, you get basis-first treatment. From an annuity or a MEC, the taxable portion comes out first.

Multiple Contracts With the Same Insurer

Section 72(e)(12) is an anti-abuse provision. All annuity contracts issued by the same company to the same policyholder in the same calendar year are treated as a single contract when applying the 72(e) rules, and the same aggregation applies to modified endowment contracts.¹ Without this, someone could buy several small annuities in one year and pull withdrawals only from the one with the lowest gain. Aggregation forces the IRS to look at combined gain across the same-year, same-insurer contracts.

Two contracts that arise from a tax-free 1035 exchange are not aggregated even if they end up at the same insurer. Revenue Procedure 2008-24 clarifies that exchanged contracts remain separate for aggregation purposes.⁴

Section 1035 Exchanges

Section 1035 lets you swap one contract for another without recognizing gain at the time of the exchange.⁵ Life insurance can be exchanged for another life policy, an endowment, an annuity, or a qualified long-term care contract. An endowment can be exchanged for another endowment (with the same or earlier payment start date), an annuity, or a long-term care contract. An annuity can be exchanged only for another annuity or a long-term care contract. A long-term care contract can only be exchanged for another long-term care contract.

The hierarchy runs one way. You can exchange a life insurance policy for an annuity, but not the reverse. Your basis and any built-in gain carry to the new contract, so you’re deferring the tax, not erasing it. The gain gets taxed under 72(e) when you eventually take distributions.

Partial 1035 exchanges are also allowed under Revenue Procedure 2011-38, provided neither contract has a withdrawal within 180 days of the exchange, with an exception for payments annuitized over 10 or more years or over a lifetime.⁶

When a Corporation or Trust Owns the Annuity

Section 72(u) removes tax deferral from an annuity held by anyone other than a natural person. If a corporation, partnership, or certain trusts own the contract, the annual increase in value is taxed as ordinary income each year, even without a withdrawal.⁷

Exceptions exist. A trust or entity holding the contract as agent for a natural person keeps tax-deferred treatment. So do annuities held under qualified retirement plans, 403(b) programs, and IRAs, along with contracts acquired by a decedent’s estate and immediate annuities that begin payments within one year of purchase.⁷ Business owners sometimes buy annuities through their companies without realizing the annual income recognition wipes out the point of a deferred product. Check the ownership before titling any contract in a business entity’s name.

The 3.8% Net Investment Income Tax

Taxable distributions from non-qualified annuities count as net investment income under Section 1411.⁸ If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), the taxable portion of your withdrawal may pick up an additional 3.8% surtax on top of ordinary income tax.⁹

The thresholds aren’t indexed for inflation. They’ve stayed at those levels since 2013 and remain the same for 2026.⁹ One big withdrawal in a single year can push you over the line even if you’d normally be under, so spreading distributions across tax years can reduce or eliminate the surtax.

Contracts Issued Before August 14, 1982

Annuities entered into before August 14, 1982 are grandfathered under 72(e)(5)(A) and keep the older basis-first treatment: withdrawals return premiums first and become taxable only after the full investment is recovered. Loans against these contracts aren’t treated as distributions, and no early-withdrawal penalty applies to the pre-1982 investment. Any money added after August 13, 1982 is treated as a new contract, so that layer falls back under the income-first rule.¹

How Distributions Get Reported

Insurers and financial institutions file Form 1099-R for each person who receives a distribution of $10 or more from an annuity, pension, insurance contract, or similar product.¹⁰ Box 1 reports the gross distribution, Box 2a the taxable amount, and Box 7 carries the distribution code that signals whether the early-distribution penalty applies. If the taxable amount on your 1099-R doesn’t match your own records of premiums paid, prior withdrawals, 1035 exchanges, and cash dividends received, contact the insurer before filing. Overstating the taxable amount overpays your tax; understating it invites scrutiny.

1
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Office of the Law Revision Counsel. 26 U.S. Code 7702A – Modified Endowment Contract Defined
4
Internal Revenue Service. Revenue Procedure 2008-24
5
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies
6
Internal Revenue Service. Revenue Procedure 2011-38
7
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
8
Internal Revenue Service. Net Investment Income Tax
9
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
10
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.