FINRA Series 6 Investment Company and Variable Contracts Products Representative ExaminationProcessing Customer Orders and TransactionsHard
A customer who purchased a variable annuity contract two years ago decides to surrender the contract. The contract has a current value of $120,000, and the customer's cost basis is $100,000. If the customer is 55 years old, what are the tax implications of this surrender?
- AThe entire $120,000 is tax-free due to the surrender.
- BThe $20,000 gain is taxable as ordinary income, subject to a 10% penalty.
- CThe entire $120,000 is taxable as ordinary income.
- DThe $20,000 gain is taxable as ordinary income, but no penalty applies.
Show answer & explanationAnswer & explanation
Correct answer: B. The $20,000 gain is taxable as ordinary income, subject to a 10% penalty.
When surrendering a variable annuity, the earnings ($120,000 current value - $100,000 cost basis = $20,000 gain) are taxable as ordinary income. Since the customer is 55, which is younger than 59½, the taxable gain is also subject to a 10% IRS penalty for early withdrawal.
Why the other options are wrong
- A. Variable annuity earnings are tax-deferred, not tax-free, and become taxable upon withdrawal.
- C. Only the gain is taxable, not the return of principal (cost basis).
- D. The 10% penalty does apply because the customer is under 59½ years old.
Variable Annuity Surrender Taxation (Under 59½)
When a variable annuity is surrendered before age 59½, any gain is taxed as ordinary income and is subject to a 10% IRS early withdrawal penalty.
- Earnings are taxed 'Last-In, First-Out' (LIFO).
- Cost basis is returned tax-free.
- Penalty applies to the taxable portion if under 59½, unless an exception applies.
Memory trick: Annuity's Age: Under 59½? Gain is Graded, Penalty Paid.