Random withdrawals on an annuity are taxed under which method?

• A. FIFO
• B. LIFO
• C. Pro rata
• D. Tax-free

Answer: (B)

The main idea is how withdrawals from a nonqualified annuity are taxed. When you fund an annuity with after-tax dollars, the earnings grow tax-deferred, and withdrawals must be taxed on a last-in, first-out basis. That means the taxable portion is the earnings first, while the return of your original after-tax contributions (the cost basis) comes later and is tax-free up to the amount you contributed. This ordering ensures that the earnings portion is taxed before any return of principal.

For example, if you put in 20,000 and the contract grows to 40,000, a 5,000 withdrawal is treated as earnings and taxed as ordinary income. You wouldn’t get tax-free treatment on that amount until you’ve recovered the 20,000 cost basis.

Other methods aren’t used for this purpose: FIFO would pull out tax-free principal first, understating the immediate tax; pro rata would spread the tax impact across withdrawals rather than forcing earnings to come out first; tax-free isn’t a method of allocation for these distributions.