Distributions from the non MEC life insurance policies are taxed basis first, gain second, while distributions from a MEC are taxed gain first, basis second. The order in which basis is withdrawn is important because basis is not taxable. The following example illustrates the difference.
Assume a policy has a cash value of $10,000 composed of $4,000 of nontaxable basis and $6,000 of taxable gain and a $7,000 distribution is taken. Because a non MEC life insurance policy is taxed basis first, gain second, only $3,000 of the distribution ( $7,000— $4,000 (basis)) would be taxed if the policy is not a MEC. However, because a MEC is taxed gain first, basis second, $6,000 of the distribution (the entire gain) would be taxed if the policy were a MEC. An additional 10% penalty tax could also apply to the $6,000 of taxable gain, if the policyowner was under age 59½.