What is the tax treatment when withdrawing from a nonqualified variable annuity?

When withdrawing from a nonqualified variable annuity, the tax treatment is based on the gains generated within the annuity and the original investment, also referred to as the cost basis. The correct answer indicates that the ordinary income tax applies only to the amount withdrawn that exceeds the original investment. This is due to the fact that the principal (original investment) is not taxed upon withdrawal because it was made with after-tax dollars.

In more detail, when you make a withdrawal from a nonqualified annuity, the withdrawal is subject to the "last in, first out" (LIFO) principle. This means that any earnings (or growth) in the annuity are considered to be withdrawn first. Thus, the portion of the withdrawal that represents earnings is taxed as ordinary income. Consequently, if the entire amount is withdrawn and includes both the principal and earnings, only the portion that exceeds the principal is subject to income taxes.

The other choices do not accurately reflect the tax implications:

• A implies that all withdrawals are tax-free, which is not the case when dealing with earnings.

• B suggests that only the original investment is taxable, neglecting the fact that any gains are taxed as income when withdrawn.

• D states that capital gains taxes apply to the