AD Banker Comprehensive Practice Exam

If an annuitant withdraws funds from their annuity prior to age 59 1/2, what is the tax consequence?

1. Tax and 10% penalty tax on the withdrawal that represents earnings

2. Tax on the entire withdrawal plus a 10% tax penalty

3. Tax on the tax deferred portion of the withdrawal along with a 15% tax penalty

4. Tax on cost basis and 10% tax penalty on the tax deferred portion of the withdrawal

The correct answer is: Tax on the tax deferred portion of the withdrawal along with a 15% tax penalty

In this scenario, when an annuitant withdraws funds from their annuity before reaching the age of 59 1/2, the tax implications primarily focus on how the withdrawal is categorized in terms of taxable income and any associated penalties. The correct outcome in this situation involves taxing the portion of the withdrawal that consists of earnings (which are typically tax-deferred) and applying a penalty for early withdrawal. Generally, when an individual withdraws from an annuity before the designated age limit, the IRS imposes a 10% early withdrawal penalty on earnings. However, the tax code does not impose a flat penalty rate on the entire withdrawal; it considers only the earnings portion for the penalty. Taxes would apply to any earnings withdrawn, as they would normally be subject to income tax since the funds were contributed pre-tax. However, the cost basis (the amount originally invested in the annuity) is not subject to a penalty or additional taxation when withdrawn. The choice that indicates a tax on the tax-deferred portion of the withdrawal along with a penalty illustrates the correct understanding of how the tax code structures these withdrawals. Unlike some options where penalties or tax implications are mischaracterized, this choice accurately reflects that only the earnings, which are tax-de