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

In terms of tax, how is the payout from an annuity typically handled when it has been funded with pre-tax dollars?

1. Tax-free payout

2. Taxed as capital gains

3. Taxed as ordinary income

4. Subject to estate tax

The correct answer is: Taxed as ordinary income

When an annuity is funded with pre-tax dollars, the payouts are typically taxed as ordinary income when they are received. This taxation occurs because the money that goes into the annuity has not yet been taxed; it was contributed before any income taxes were applied. Therefore, when distributions are made, the full amount comes subject to ordinary income tax rates. This structure is particularly significant in retirement planning since individuals often contribute to their annuities with the assumption that they will be in a lower tax bracket upon retirement; thus, they may end up paying less tax on these distributions compared to if they had paid taxes on the contributions earlier. The other possible tax treatments do not apply in this situation. For instance, taxable capital gains taxation is not relevant for annuities funded with pre-tax dollars, as annuities themselves do not generate capital gains in the same way stocks or certain other investments do. Similarly, while annuities might be subject to estate taxes upon the owner’s death, this situation does not pertain to the income tax treatment of payouts during the owner's lifetime. Lastly, payouts from the annuity are not tax-free; they represent income received, and tax obligations apply accordingly.