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A
The full $30,000 is taxable as ordinary income
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B
For non-MEC policies, partial surrenders use FIFO — basis comes out first, tax-free; since the basis ($45,000) exceeds the amount withdrawn ($30,000), the entire $30,000 is a return of basis and is NOT taxable; tax would apply only if withdrawals exceeded the $45,000 basis
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C
The $30,000 is taxed as a capital gain
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D
The gain is calculated as $30,000 × (gain/total cash value)
Why this is the answer
TAXATION OF PARTIAL SURRENDERS from non-MEC life insurance policies uses FIFO (First In, First Out) accounting — the policyholder's own cost basis is considered to come out first, before any gain. CALCULATION: Basis = $45,000 (premiums paid minus any dividends received on a tax-free basis); Cash value = $80,000; Total gain = $80,000 − $45,000 = $35,000; Partial surrender = $30,000; FIFO RESULT: The first $45,000 of withdrawals are tax-free (return of basis); the remaining gain ($35,000) would be taxable only after all basis is recovered; since $30,000 < $45,000 basis, NO TAX is owed on this withdrawal. CONTRAST WITH MEC POLICIES: MECs use LIFO — gain comes out first; the same $30,000 withdrawal from a MEC with $35,000 of gain would result in $30,000 being taxable PLUS the 10% penalty if under age 59½. CONTRAST WITH ANNUITIES: Annuities also use LIFO — gain comes out first; CONTRAST WITH POLICY LOANS: Policy loans from non-MEC policies are NOT taxable as long as the policy remains in force (loans are not income, they are debt); if the policy lapses with an outstanding loan exceeding the basis, the gain is taxable in the lapse year. PRACTICAL IMPLICATION: For clients who need to access cash value, partial surrenders from non-MEC policies are very tax-efficient as long as withdrawals stay within the cost basis.
Source: Life Insurance License Exam, Taxation of Partial Surrenders