An investor who is 50 years old takes a full surrender of a non-qualified variable annuity contract that was purchased three years ago. The contract was initially funded with a single premium payment of 55,000. The insurance contract carries a 5% insurance surrender fee on early withdrawals. Which of the following statements correctly describes the federal income tax treatment of the earnings upon surrender?
- The $15,000 of earnings is taxed as ordinary income and is subject to an additional 10% IRS tax penalty for early distribution.Answer
- BThe entire $55,000 surrender amount is taxed as long-term capital gains, with no additional IRS early withdrawal tax penalty.
- CThe $15,000 of earnings is taxed as a long-term capital gain, and the insurer's 5% surrender charge waives the 10% IRS tax penalty.
- DThe earnings are distributed tax-free because the surrender occurs prior to annuitization.
Answer
The $15,000 of earnings is taxable as ordinary income and subject to a 10% IRS tax penalty because the distribution occurs prior to age 59 1/2.
For non-qualified variable annuities, growth accumulates on a tax-deferred basis. When distributions or full surrenders are taken prior to annuitization, IRS rules specify LIFO (last-in, first-out) tax treatment, meaning earnings are distributed first. The 55,000 cash value minus $40,000 cost basis) is taxable as ordinary income. Furthermore, because the investor is under age 59 1/2, the taxable portion is subject to a 10% IRS early distribution penalty in addition to ordinary income tax.
Step-by-Step Solution
Key Concept
Taxation of Non-Qualified Variable Annuity Distributions and Premature Penalties