In a nonqualified deferred annuity, how are withdrawals taxed during the accumulation phase under the standard tax rule?
Explanation
For nonqualified annuities purchased after August 13, 1982, withdrawals follow last-in, first-out (LIFO) tax treatment: the taxable earnings (interest) are treated as coming out first and are taxed as ordinary income, and a 10% penalty may apply before age 59 1/2. The already-taxed principal (cost basis) comes out only after the earnings are exhausted, so treating the principal as coming out first reverses the order. Annuity gains are ordinary income, so they are neither entirely tax-free nor taxed at long-term capital gain rates. During annuitization, the exclusion ratio instead spreads the return of basis across each payment.
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