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Question

Difficulty: MediumAnnuities and Insurance-Based Products

An investor who is 52 years old holds a non-qualified variable annuity with an original purchase payment of 100,000.Thecontractvaluehasgrownto100,000. The contract value has grown to 140,000. The investor executes a partial withdrawal of $30,000 while still within the contract's 6-year surrender charge period. Assuming the insurance company assesses a 5% surrender charge on the amount withdrawn, which of the following best describes the tax consequences and penalty obligations resulting from this transaction?

  1. A
    The entire $30,000 withdrawal is subject to ordinary income tax and an additional 10% IRS penalty, in addition to the insurer's surrender fee.
  2. The $30,000 withdrawal is treated as taxable ordinary income and is subject to an additional 10% IRS tax penalty, plus the contract surrender charge.Answer
  3. C
    The $30,000 withdrawal is treated as a tax-free return of capital, but the investor must pay the 5% insurance contract surrender fee.
  4. D
    The $30,000 withdrawal is taxable as a long-term capital gain and is exempt from the 10% IRS penalty because a surrender charge was assessed.

Answer

The $30,000 withdrawal is treated as taxable ordinary income and is subject to an additional 10% IRS tax penalty, plus the contract surrender charge.
Under IRS rules, distributions from non-qualified variable annuities during the accumulation phase are taxed on a LIFO (Last-In, First-Out) basis. Because the contract has 40,000inaccumulatedearnings,theentire40,000 in accumulated earnings, the entire 30,000 withdrawal is considered earnings and taxed as ordinary income. Since the contract owner is 52 years old (under 59½), the taxable portion is also subject to the 10% IRS premature distribution penalty. Furthermore, withdrawing funds during the surrender period incurs the insurer's contractual surrender charge.

Step-by-Step Solution

1
Determine the tax accounting method for partial withdrawals from non-qualified variable annuities.
Partial withdrawals are taxed on a Last-In, First-Out (LIFO) basis, meaning earnings are distributed prior to principal.
IRS rules govern non-qualified annuity distributions to ensure accumulated tax-deferred earnings are taxed first.
2
Compare the withdrawal amount to the total accumulated earnings in the contract.
Total accumulated earnings are 40,000(40,000 ( 140,000 contract value − 100,000costbasis).Theentire100,000 cost basis). The entire 30,000 withdrawal represents taxable earnings.
Since the 30,000withdrawalislessthanthe30,000 withdrawal is less than the 40,000 in earnings, 100% of the withdrawal is taxed as ordinary income.
3
Identify IRS premature distribution tax penalties and contract surrender fees based on investor age and contract terms.
Because the investor is under age 59½ (age 52), an additional 10% IRS tax penalty applies to the $30,000 taxable amount. Additionally, the insurance company assesses its standard 5% surrender charge.
Federal tax penalties for early withdrawal before age 59½ are distinct from and cumulative with contractual insurer surrender fees.

Key Concept

Taxation and penalty mechanics of partial withdrawals from non-qualified variable annuities
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Topics

Annuities and Insurance-Based Products

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