When an investor takes a lump-sum distribution from a nonqualified variable annuity, how are the earnings taxed?

When an investor takes a lump-sum distribution from a nonqualified variable annuity, the earnings are taxed as ordinary income. This taxation reflects the fact that the contributions to a nonqualified variable annuity are made with after-tax dollars, meaning that the initial investment is not taxed again upon withdrawal. However, any earnings or growth within the annuity, which may have accumulated on a tax-deferred basis, are subject to ordinary income tax rates when distributed. This approach is consistent across nonqualified annuities, reinforcing the understanding that while the principal remains untouched by taxation, the growth segments are treated as taxable income.

In the context of the options provided, this framework clarifies typical misunderstandings regarding taxation strategies associated with lump-sum withdrawals from investment vehicles, especially distinguishing the treatment of earnings from different types of accounts.