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Difficulty: Very hardAnnuities and Insurance-Based Products

A 52-year-old investor surrenders a non-qualified variable annuity contract after five years of accumulation, withdrawing the full account balance of 150,000againstaninitialcostbasisof150,000 against an initial cost basis of 100,000. The contract carries a 4% contingent deferred sales charge (CDSC) for surrenders within six years. Which of the following statements regarding the tax consequences and fee mechanics of this surrender are CORRECT?

  1. The $50,000 gain is taxed as ordinary income under last-in, first-out (LIFO) accounting rules.Answer
  2. The 10% IRS early withdrawal penalty applies exclusively to the $50,000 taxable earnings portion.Answer
  3. C
    The 10% IRS penalty is levied against the entire $150,000 gross surrender value prior to deducting insurance company fees.
  4. D
    The contingent deferred sales charge paid to the insurer reduces the investor's tax liability dollar-for-dollar as a direct federal tax credit.

Answer

The taxable gain of 50,000istaxedasordinaryincomeunderLIFOrules,andthe1050,000 is taxed as ordinary income under LIFO rules, and the 10% IRS early withdrawal tax penalty applies only to that 50,000 earnings portion.
Under federal tax law, non-qualified variable annuity distributions prior to annuitization follow LIFO tax treatment, placing taxable earnings (50,000)firstbeforethetax−freereturnofcostbasis(50,000) first before the tax-free return of cost basis ( 100,000). Furthermore, because the contract holder is under age 59½, the 10% IRS tax penalty is assessed strictly on the $50,000 earnings portion, not on the total surrender value.

Step-by-Step Solution

1
Determine the taxable income component using LIFO rules
Gross surrender (150,000)minuscostbasis(150,000) minus cost basis ( 100,000) equals $50,000 earnings taxed at ordinary income rates.
IRS rules specify that non-qualified annuity withdrawals during the accumulation phase follow LIFO accounting (earnings out first).
2
Apply the IRS early withdrawal tax penalty criteria
A 10% penalty applies to the 50,000taxablegain,resultingina50,000 taxable gain, resulting in a 5,000 tax penalty.
Because the investor is 52 years old (under the age 59½ threshold), premature distribution tax penalties apply specifically to taxable earnings, not principal.
3
Differentiate contractual insurer fees from federal tax penalties
The 4% CDSC surrender charge ($6,000) is deducted by the insurance company and is distinct from IRS income taxes and tax penalties.
Insurer surrender charges compensate the issuing firm for early contract termination and do not offset or credit against federal income tax obligations.

Key Concept

Taxation of Non-Qualified Variable Annuity Surrenders and Penalty Calculations
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Topics

Annuities and Insurance-Based Products

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