Any portion of distributions exceeding the cost basis is taxed as what?

• A. Capital gains rates
• B. Ordinary income
• C. Tax-free
• D. Favorable rates

Answer: (B)

The key idea is how distributions from a tax-deferred contract are taxed based on what part is return of your investment (cost basis) versus earnings. When a distribution is more than what you originally contributed, the excess represents earnings inside the contract. Those earnings are taxed as ordinary income, not at capital gains rates, because they come from the growth inside the tax-deferred vehicle, not from the sale of a separate asset. The portion that equals your cost basis is a return of principal and is not taxed. So, the portion exceeding the cost basis is taxed as ordinary income.