section 1 - The American College Online Learning Center

(7) Based on ordering rules, identify which accounts to withdrawal from forthe current year.LO 4-1-5: Understand the tax treatment of annuities1. Qualified annuities (are annuities held inside a qualified plan, IRA, or 403(b) plan) (Video:What is the tax treatment of a nonqualified annuity? Littell, Tacchino, Ivers)a. Qualified annuities receive the same tax treatment as other assets held intax-deferred plans.b. Generally this means that distributions are taxed as ordinary income.c. Withdrawals prior to age 59½ are subject to the 10% early withdrawal penaltyunless an exception applies.2. Nonqualified annuitiesa. General rule—nonqualified annuities are funded with after-tax dollars, sopremiums become the policyowner’s cost basis and growth will be taxed only atthe time of withdrawal.b. During the accumulation period, income tax is deferred.(1) Accumulation period implies that there are no withdrawals.(2) To qualify for deferral of taxation, the annuity must generally be held by anatural person (several exceptions apply).c. The tax treatment of withdrawals made during the pre-annuitization phase:(1) Assuming there have been earnings (gain in the value of the contract), thefirst withdrawals from the annuity are considered earnings.(2) Example: An annuity has a current value of $15,000 and premiumpayments (cost basis) is only $10,000. The owner wants to withdraw$2,000. Since there has been a gain of $5,000, the first $2,000 withdrawnis treated as gain and is fully includable as ordinary income subject toincome tax.(3) Withdrawals are also subject to the 10% early withdrawal penalty.(a) The tax only applies to the taxable portion of the withdrawal priorto attainment of age 59½ at the time of the distribution (not at theend of the tax year).(b) The penalty does not apply to• A stream of annuity payments• Payments as a result of disability• Distributions after the death of policyowner• Distributions that are part of a stream of substantially equalperiodic payments(c) The exceptions for medical expenses, education expenses, andseparation from service at age 55 do not apply to a nonqualifiedannuity, so the 10 percent penalty will apply under thesecircumstances.d. Tax treatment upon policy surrender(1) Difference between the cash surrender value and cost basis is subject toincome tax.(2) 10% early withdrawal penalty may apply as well4.19