Florida 2-15 Life, Health and Variable Annuity AgentGeneral Knowledge of Life InsuranceMedium
A client purchased a non-qualified deferred annuity with a single premium of $100,000. Over time, the annuity has grown to a cash value of $125,000. If the client makes a withdrawal of $10,000 from the annuity, how will this withdrawal be taxed?
- AThe entire $10,000 withdrawal will be considered taxable ordinary income.
- BThe first $10,000 withdrawn will be taxed as a penalty, then as ordinary income.
- CThe entire $10,000 withdrawal will be considered a tax-free return of principal.
- DThe withdrawal will be prorated, with a portion being taxable gain and a portion being tax-free principal.
Show answer & explanationAnswer & explanation
Correct answer: A. The entire $10,000 withdrawal will be considered taxable ordinary income.
For non-qualified annuities, withdrawals are taxed on a 'Last-In, First-Out' (LIFO) basis. This means earnings are considered to be withdrawn first and are subject to ordinary income tax. Since the client has $25,000 in earnings ($125,000 - $100,000), the entire $10,000 withdrawal is considered taxable earnings.
Why the other options are wrong
- B. A penalty (10% if under 59 1/2) might apply, but the question asks about how the withdrawal will be 'taxed' (as income), not about potential penalties. The income itself is still ordinary income.
- C. This would only be true if there were no earnings, or if the annuity was qualified and in the payout phase (using exclusion ratio).
- D. Prorated taxation applies to annuity payments (annuitization), not typically to partial withdrawals from a deferred annuity before annuitization.
Non-Qualified Annuity Withdrawal Taxation (LIFO)
For non-qualified deferred annuities, withdrawals are taxed on a 'Last-In, First-Out' (LIFO) basis, meaning earnings are withdrawn first and are subject to ordinary income tax.
- Earnings are taxed as ordinary income
- Principal is returned tax-free only after all earnings are withdrawn
- A 10% penalty may apply if withdrawn before age 59 1/2
- Applies to partial withdrawals from a deferred annuity
Memory trick: Annuity withdrawals: 'LIFO' for non-qualified, 'Exclusion' for qualified payouts.