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Difficulty: MediumAnnuities and Insurance-Based Products

A 62-year-old investor takes a partial lump-sum withdrawal from a non-qualified variable annuity contract that has accumulated significant investment growth above the original contribution basis. Which of the following statements regarding the tax implications of this distribution are CORRECT?

  1. The growth portion of the withdrawal is taxed as ordinary income in the year received.Answer
  2. B
    The taxable portion of the withdrawal is subject to a 10% IRS penalty tax for early withdrawal.
  3. The distribution is accounted for on a Last-In, First-Out (LIFO) basis for federal income tax purposes.Answer
  4. D
    The distribution is accounted for on a First-In, First-Out (FIFO) basis, allowing tax-free principal to be withdrawn first.

Answer

The withdrawal is taxed using Last-In, First-Out (LIFO) accounting rules, making accumulated growth taxable first as ordinary income. Since the contract owner is age 62 (past age 59½), the 10% IRS early distribution tax penalty does not apply.
For partial surrenders of non-qualified variable annuities, the IRS applies Last-In, First-Out (LIFO) tax rules. Under LIFO rules, all accumulated investment earnings are distributed first and taxed at ordinary income tax rates. Additionally, because the investor is 62 years old, they have passed the age threshold of 59½ and are exempt from the 10% early withdrawal tax penalty.

Step-by-Step Solution

1
Determine the tax accounting method for random non-qualified annuity withdrawals prior to annuitization.
The IRS mandates Last-In, First-Out (LIFO) taxation, meaning growth and earnings are withdrawn before original cost basis.
IRS Code Section 72(e) stipulates LIFO treatment for non-qualified annuity surrenders.
2
Evaluate tax rates applicable to the withdrawn earnings.
Earnings are taxed at the contract owner's ordinary income tax rate rather than preferential capital gains rates.
Annuity growth is always treated as ordinary income upon cash distribution.
3
Check for applicability of the IRS 10% premature distribution penalty tax.
No 10% penalty tax applies because the contract owner is 62 years old.
The 10% IRS early withdrawal penalty applies only to taxable distributions made prior to reaching age 59½.

Key Concept

Non-Qualified Variable Annuity Taxation and LIFO Accounting
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Topics

Annuities and Insurance-Based Products

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