What happens when taking a lump-sum partial withdrawal from a nonqualified annuity?

When taking a lump-sum partial withdrawal from a nonqualified annuity, the treatment of withdrawals for tax purposes is governed by the Internal Revenue Code. The correct answer reflects that the interest and earnings portion accumulated in the annuity is taxable as ordinary income when a partial withdrawal is made.

Nonqualified annuities are funded with after-tax dollars, meaning the purchase payments (or principal) are not taxed upon withdrawal. However, any gains, interest, or earnings that have accrued in the account are subject to taxes as ordinary income. This is because the tax code specifies that withdrawals from these contracts are treated as a return of capital until the investment in the contract has been fully recovered. Therefore, when a partial withdrawal occurs, it is the earnings that come out first for taxation.

In essence, this means that the initial amount put into the annuity is usually tax-free when withdrawn, while the earnings on that amount become taxable upon withdrawal. Understanding this taxation order is essential for managing withdrawals from nonqualified annuities effectively.