Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

In a non-qualified annuity, how is a single distribution taxed?

1. As capital gains

2. As ordinary income

3. Tax-free

4. At the rate of the annuity issuer

The correct answer is: As ordinary income

In a non-qualified annuity, withdrawals or distributions are taxed as ordinary income because the contributions made to the annuity are made with after-tax dollars. This means that the initial contributions have already been taxed. When distributions are taken, the earnings portion of the distribution is subject to ordinary income tax. In a single distribution scenario, the entire amount that exceeds the investment in the annuity (known as the cost basis) is subject to taxation as ordinary income. This approach ensures that investors pay taxes on the growth of their investment only upon withdrawal. Therefore, when a single distribution occurs from a non-qualified annuity, it represents the accumulation of earnings, which are taxed according to the ordinary income tax rates applicable to the individual’s tax bracket. This treatment distinguishes non-qualified annuities from other types of investments, where capital gains tax may apply, and highlights the importance of understanding the taxation differences relevant to annuities specifically.