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Difficulty: HardAnnuities and Insurance-Based Products

A 45-year-old investor surrenders a non-qualified variable annuity contract valued at 120,000,intowhich120,000, into which 80,000 in non-deductible cash contributions were made over the past four years. The insurance company levies a 5% contingent deferred surrender charge on the total contract value withdrawn. Which of the following statements correctly describes the tax treatment and penalty structure applicable to this surrender?

  1. The $40,000 earnings portion is taxed as ordinary income and is subject to an additional 10% IRS tax penalty, while the 5% surrender charge is assessed separately by the insurance company.Answer
  2. B
    The entire 120,000distributionissubjecttoa10120,000 distribution is subject to a 10% IRS early withdrawal penalty, but the 40,000 growth is taxed at favorable long-term capital gains rates.
  3. C
    The original $80,000 contribution is distributed first tax-free under FIFO rules, resulting in zero current tax liability or IRS penalties.
  4. D
    Because the insurance company assesses a 5% contingent deferred surrender charge, the IRS waives the 10% early withdrawal penalty on the accumulated growth.

Answer

The $40,000 earnings portion is taxed as ordinary income and is subject to an additional 10% IRS tax penalty, while the 5% surrender charge is assessed separately by the insurance company.
For non-qualified variable annuities, non-annuitized surrenders are taxed on a Last-In, First-Out (LIFO) basis. Accumulated earnings (40,000)aredistributedbeforecostbasis(40,000) are distributed before cost basis ( 80,000) and are taxed as ordinary income. Because the investor is age 45 (under 59½), the IRS imposes an additional 10% tax penalty on the $40,000 taxable portion. Contractual surrender charges levied by the insurance company are separate obligations and do not alter IRS taxation or penalty rules.

Step-by-Step Solution

1
Determine the taxable gain and principal basis of the contract.
Contributions (80,000)representcostbasis;remainingbalance(80,000) represent cost basis; remaining balance ( 40,000) represents accumulated tax-deferred growth.
Non-qualified annuities are funded with after-tax dollars.
2
Apply federal tax accounting rules (LIFO) for premature withdrawals.
Earnings ($40,000) are distributed first and treated as ordinary income.
IRS rules mandate Last-In, First-Out (LIFO) tax distribution ordering for non-annuitized variable annuity surrenders.
3
Evaluate age-based IRS penalties and insurer-specific charges.
The investor is under age 59½ (age 45), triggering a 10% IRS early distribution penalty on the $40,000 taxable growth. The 5% surrender charge is a contractual fee assessed by the insurance provider based on contract terms.
IRS penalties and insurance surrender fees operate independently.

Key Concept

Taxation and Surrender Penalties of Non-Qualified Variable Annuities
Estimated Time:1m 30s
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Topics

Annuities and Insurance-Based Products

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