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Difficulty: MediumAnnuities and Insurance-Based Products

An investor, age 55, makes a single partial withdrawal of 20,000fromanon−qualifiedvariableannuitycontract.Priortothewithdrawal,thecontracthadanoriginalcostbasisof20,000 from a non-qualified variable annuity contract. Prior to the withdrawal, the contract had an original cost basis of 50,000 and an total accumulation value of 80,000.Howwillthis80,000. How will this 20,000 withdrawal be treated for federal income tax purposes?

  1. The entire $20,000 is taxed as ordinary income and is subject to a 10% IRS early withdrawal penalty.Answer
  2. B
    The 20,000isreceivedcompletelytax−freebecausetotalwithdrawalshavenotyetexceededtheoriginal20,000 is received completely tax-free because total withdrawals have not yet exceeded the original 50,000 cost basis.
  3. C
    The $20,000 is taxed entirely at long-term capital gains tax rates, with no additional penalty.
  4. D
    The withdrawal is split proportionally between tax-free return of basis (12,500)andtaxableordinaryincome(12,500) and taxable ordinary income ( 7,500).

Answer

The entire $20,000 is taxed as ordinary income and is subject to a 10% IRS early withdrawal penalty.
Under IRS regulations, partial surrenders or random withdrawals from a non-qualified variable annuity during the accumulation stage are taxed on a Last-In, First-Out (LIFO) basis. This means all earnings (growth above the cost basis) are distributed first and taxed as ordinary income. Since the contract has 30,000ingrowthandtheinvestorwithdrew30,000 in growth and the investor withdrew 20,000, the full amount consists of taxable earnings. Additionally, because the investor is age 55 (under 59½), the withdrawal incurs a 10% IRS tax penalty on the earnings distributed.

Step-by-Step Solution

1
Determine the growth portion of the annuity contract.
Growth = 80,000accumulatedvalue−80,000 accumulated value - 50,000 cost basis = $30,000.
Variable annuity tax rules require identifying earnings before determining taxability.
2
Apply the appropriate tax distribution method (LIFO) for partial surrender withdrawals during the accumulation phase.
Since 20,000islessthanthe20,000 is less than the 30,000 of accumulated earnings, the entire $20,000 is drawn from earnings.
IRS code mandates Last-In, First-Out (LIFO) accounting for non-qualified annuity withdrawals.
3
Assess the applicable tax rate and early withdrawal penalties based on investor age.
The earnings are taxed at ordinary income tax rates and assessed an additional 10% penalty because the investor is under 59½.
Annuity growth is taxed as ordinary income, and premature distributions prior to age 59½ incur a mandatory 10% penalty unless a specific exemption applies.

Key Concept

Taxation of Non-Qualified Variable Annuity Withdrawals (LIFO Rules and IRS Penalties)
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Topics

Annuities and Insurance-Based Products

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