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Difficulty: HardAnnuities and Insurance-Based Products

A 50-year-old investor holds a non-qualified variable annuity contract into which she originally invested a single premium of 100,000.Overaten−yearperiod,theaccumulationvalueoftheannuityincreasesto100,000. Over a ten-year period, the accumulation value of the annuity increases to 160,000. The investor takes a partial surrender of 30,000fromthecontracttofundahomerenovationproject.Howisthis30,000 from the contract to fund a home renovation project. How is this 30,000 distribution classified for federal income tax purposes?

  1. The entire $30,000 distribution is taxed as ordinary income and is subject to an additional 10% IRS early withdrawal tax penalty.Answer
  2. B
    The entire 30,000distributionisreceivedasatax−freereturnofcapital,reducingtheinvestor′scostbasisintheannuityto30,000 distribution is received as a tax-free return of capital, reducing the investor's cost basis in the annuity to 70,000.
  3. C
    The 30,000distributionissplitpro−rata,with30,000 distribution is split pro-rata, with 18,750 treated as tax-free cost basis and $11,250 taxed as long-term capital gains.
  4. D
    The $30,000 distribution is taxed as ordinary income, but it is exempt from the 10% IRS penalty tax because the funds are used for home improvements.

Answer

The entire $30,000 distribution is taxed as ordinary income and is subject to an additional 10% IRS early withdrawal tax penalty.
For non-qualified variable annuities, partial withdrawals prior to annuitization are taxed on a Last-In, First-Out (LIFO) accounting basis. This means all earnings built up in the contract are deemed to be withdrawn first before any tax-free original cost basis is returned. Here, accumulated earnings are 60,000(60,000 ( 160,000 contract value − 100,000basis).Becausethe100,000 basis). Because the 30,000 withdrawal is less than the 60,000ofavailableearnings,theentire60,000 of available earnings, the entire 30,000 is taxed as ordinary income. Furthermore, because the owner is age 50 (below the IRS threshold of 59½), the taxable $30,000 is also subject to an additional 10% IRS penalty tax.

Step-by-Step Solution

1
Determine total tax-deferred earnings in the non-qualified variable annuity contract.
Contract value of 160,000minuscostbasisof160,000 minus cost basis of 100,000 yields $60,000 in accumulated growth/earnings.
Tax rules measure earnings as any accumulation value in excess of total original contributions.
2
Apply federal tax distribution ordering rules for non-qualified annuity partial surrenders.
Partial surrenders are taxed on a Last-In, First-Out (LIFO) basis, meaning taxable earnings are withdrawn before non-taxable cost basis.
Internal Revenue Code Section 72(e) mandates LIFO tax treatment for random withdrawals prior to annuitization.
3
Calculate the taxable portion of the $30,000 withdrawal.
Because total accumulated earnings (60,000)exceedthewithdrawalamount(60,000) exceed the withdrawal amount ( 30,000), the full $30,000 consists of earnings taxed as ordinary income.
All distributed earnings are taxed at ordinary income tax rates, not capital gains rates.
4
Evaluate the application of the IRS early withdrawal penalty tax based on investor age.
An additional 10% IRS penalty tax applies to the taxable $30,000 because the investor is 50 years old (under age 59½) and no statutory exception applies.
Unless a qualifying exemption applies (such as disability or death), early distributions of earnings before age 59½ incur a 10% penalty tax.

Key Concept

Taxation of Non-Qualified Variable Annuity Partial Surrenders (LIFO & 10% IRS Penalty)
Estimated Time:1m 30s
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Topics

Annuities and Insurance-Based Products

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