FINRA Series 7Investment Information and Suitable RecommendationsMedium
A 45-year-old client invested $40,000 in a nonqualified variable annuity that has grown to $60,000. She withdraws $10,000 for an emergency. How much of the withdrawal is subject to ordinary income tax and the 10% early withdrawal penalty?
- A$10,000, since gains are withdrawn first under LIFO
- B$2,500, representing the proportional gain
- C$0, since it is a return of principal
- D$5,000, split evenly between gain and principal
Show answer & explanationAnswer & explanation
Correct answer: A. $10,000, since gains are withdrawn first under LIFO
Nonqualified annuity withdrawals are taxed on a LIFO (last-in, first-out) basis, meaning earnings are considered withdrawn first. Since the annuity has $20,000 of gain ($60,000 − $40,000), the entire $10,000 withdrawal is treated as gain, fully taxable as ordinary income, and subject to a 10% penalty since the client is under age 59½.
Why the other options are wrong
- B. Incorrect — pro-rata treatment applies to qualified plans, not nonqualified annuities.
- C. Incorrect — under LIFO tax treatment, gains come out before principal.
- D. Incorrect — nonqualified annuities do not split withdrawals evenly.
Nonqualified Annuity Withdrawal Taxation
Withdrawals from nonqualified annuities are taxed LIFO — earnings are withdrawn (and taxed) first, before return of principal, and are subject to a 10% penalty if taken before age 59½.
- LIFO taxation applies to nonqualified annuities
- Gains taxed as ordinary income, not capital gains
- 10% penalty applies before age 59½
- Principal withdrawals (after gains exhausted) are tax-free
Memory trick: LIFO: 'Last money in is first money taxed.'