CFP - Risk Management and Insurance Planning (11% of the exam) - Section C.22

Qualified and Non-Qualified Annuities

Fixed, variable, indexed, immediate and deferred annuities; accumulation and annuitisation phases; exclusion ratio and last-in-first-out taxation of non-qualified withdrawals; the 10% penalty before age 59 and a half; 1035 exchanges; and how an annuity held inside a qualified plan differs in tax treatment.

Internal Revenue Code Section 72Internal Revenue Code Section 1035

Practice question for this objective

Free sampleRisk Management and Insurance Planninghard

Dev, aged 52, owns a non-qualified deferred annuity he bought in 2009 with 100,000 dollars of after-tax money. The contract is now worth 160,000 dollars, it has never been annuitised, and the surrender charge period has expired. To fund a home extension he withdraws 50,000 dollars in cash. His marginal federal income tax rate is 24 per cent and no exception to the additional tax applies. What is the total federal tax cost of the withdrawal?

ANothing, because the 50,000 dollars is drawn from his 100,000 dollars of premiums before any earnings are treated as distributed.
B6,375 dollars, being 4,500 dollars of income tax on the earnings share plus a 1,875 dollar additional tax.
C12,000 dollars of income tax on the whole withdrawal, with no additional tax because the contract is not a retirement plan.
D17,000 dollars, being 12,000 dollars of income tax on the whole withdrawal plus a 5,000 dollar additional tax. Correct

Tax a pre-annuitisation withdrawal from a post-1982 non-qualified deferred annuity as earnings first, ordinary income, with the 10 per cent additional tax before age 59 and a half. A cash withdrawal before annuitisation from a non-qualified annuity issued after 14 August 1982 is last-in-first-out: earnings are treated as distributed before basis. The contract holds 160,000 dollars against 100,000 dollars of basis, so 60,000 dollars of earnings are available and the entire 50,000 dollar withdrawal falls within them. Ordinary income tax is 50,000 times 0.24, which is 12,000 dollars. The additional tax is 50,000 times 0.10, which is 5,000 dollars. Adding 12,000 and 5,000 gives 17,000 dollars. Annuity earnings are ordinary income regardless of how long the contract has been held.

Why A is wrong: This applies first-in-first-out ordering, which governs contracts issued on or before 14 August 1982. Dev's 2009 contract is subject to last-in-first-out ordering, so earnings are treated as coming out first and the withdrawal is not a tax-free return of premium.

Why B is wrong: This prorates the withdrawal between basis and gain using the 37.5 per cent earnings share of the account value. Pro rata treatment applies to amounts received as an annuity after annuitisation, not to a pre-annuitisation withdrawal from a contract issued after 14 August 1982.

Why C is wrong: The ordering rule is applied correctly here, but the 10 per cent additional tax reaches taxable amounts from non-qualified annuities as well as from retirement plans. Dev is 52 and meets no exception, so the 5,000 dollar additional tax applies.

Why D is correct: Under last-in-first-out ordering the contract's 60,000 dollars of earnings are deemed distributed first, so the entire 50,000 dollars is ordinary income. Tax at 24 per cent is 12,000 dollars, and the 10 per cent additional tax on the taxable amount before age 59 and a half adds 5,000 dollars.

See more CFP practice questions, answers explained.

Exam traps in Risk Management and Insurance Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The whole 150,000 dollars moves free of current tax, because an exchange of one annuity contract for another is not a taxable event and the cash simply reduces the new contract's value.
Why it is wrong: The direct carrier-to-carrier transfer of 130,000 dollars does qualify for non-recognition, but cash retained by the owner is boot and falls outside that protection. Treating the 20,000 dollars as part of the exchange ignores the amount she actually received in hand.
None of the 40,000 dollars is taxable, because a withdrawal from a life policy recovers premiums paid before any gain, and no additional tax applies.
Why it is wrong: This is the correct answer for a contract that is not a modified endowment contract, where withdrawals are recovered first out of investment in the contract. Once the seven-pay test is failed that first in first out ordering is switched off, so basis recovery does not come first.

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