SIE practice questionmediumVariable Annuities — Tax Treatment
How are withdrawals from a non-qualified variable annuity taxed?
- AWithdrawals are always tax-free after age 59½
- BWithdrawals are taxed as capital gains
- CAll withdrawals are tax-free
- DEarnings are withdrawn first and taxed as ordinary income; return of principal (cost basis) is tax-free✓ Correct answer
Explanation
Why D — Earnings are withdrawn first and taxed as ordinary income; return of principal (cost basis) is tax-free
Non-qualified variable annuities use LIFO (last-in, first-out) tax treatment — earnings come out first and are taxed as ordinary income (not capital gains). Once all earnings are withdrawn, the remaining cost basis is returned tax-free. Withdrawals before age 59½ may also incur a 10% IRS early withdrawal penalty on the taxable portion. The tax-deferral benefit is the key advantage of annuities.
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