Understanding Tax Treatment of Nonqualified Variable Annuity Withdrawals Based on Income Type

H owns a nonqualified variable annuity that has a separate account invested in the stock market. If H withdraws funds from the annuity, the earnings on the withdrawal will be taxed as:AOrdinary incomeBShort-term capital gainsCLong-term capital gainsDDividend income

A: Ordinary Income-Regardless of the source of the gains inside an annuity, all taxable withdrawals are subject to ordinary income tax rates.

The tax treatment of a withdrawal from a nonqualified variable annuity depends on the type of income earned on the withdrawal.

The earnings on the withdrawal from the annuity will be taxed as ordinary income if they represent growth on pre-tax contributions or gains earned on the investment. This means that the amount withdrawn will be taxed at H’s ordinary income tax rate, which may be higher than other tax rates.

If the withdrawal includes any earnings on investments held for less than one year, then those earnings will be taxed at H’s short-term capital gains rate, which is the same rate as ordinary income.

If the earnings on the withdrawal represent gains on investments held for more than one year, then those earnings will be taxed at H’s long-term capital gains rate. This rate varies based on H’s income level and can be lower than the ordinary income tax rate.

Finally, if the earnings on the withdrawal come from qualified dividends, they will be taxed as dividend income. The tax rate for qualified dividends ranges from 0% to 20% depending on H’s income level.

Therefore, the answer to the question is A) Ordinary income.

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