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

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What is the tax situation for a qualified annuity when the entire amount is withdrawn?

Only the original investment amount is taxed
The entire withdrawal amount is taxed as ordinary income
Withdrawal is tax-free
Only the earnings from the investment are taxed

The correct answer is: The entire withdrawal amount is taxed as ordinary income

When a qualified annuity is fully withdrawn, the entire withdrawal amount is taxed as ordinary income because qualified annuities are typically funded with pre-tax dollars. This means that contributions to the annuity were made before any income tax was deducted, allowing the investment to grow tax-deferred. When funds are eventually withdrawn, whether in full or partially, the money that is taken out reflects both the original contributions and the earnings accrued over time. Since all contributions to a qualified annuity come from pre-tax dollars, the Internal Revenue Service (IRS) requires that both the principal and the earnings be taxed upon withdrawal. As a result, the full amount withdrawn is considered ordinary income in the year of the withdrawal, subject to ordinary income tax rates. This tax treatment aligns with the guidelines established for qualified retirement accounts, which are designed to encourage saving for retirement. Traditional tax-deferred accounts, such as 401(k)s and IRAs, follow similar rules, where tax advantages are offered in exchange for the eventual taxation of withdrawals as ordinary income.