Ordinary Income

Which statement correctly describes a traditional IRA?

1. A.There are no required minimum distributionsTraditional IRAs require minimum distributions beginning at age 73.
2. B.Contributions may be tax-deductible and withdrawals are taxed as ordinary incomeCorrect — that is the traditional IRA tax structure: deduct now, pay tax on withdrawals later.
3. C.Withdrawals are always tax-free after age 59 and a halfTraditional IRA withdrawals are taxed as ordinary income, whatever the age.
4. D.Contributions are after-tax and qualified withdrawals are tax-freeThat describes a Roth IRA, not a traditional IRA.

Why: Traditional IRA contributions may be tax-deductible, the account grows tax-deferred, and withdrawals in retirement are taxed as ordinary income.

A withdrawal from a traditional IRA before age 59 and a half generally incurs:

1. A.A 10% penalty plus ordinary income taxCorrect - penalty plus income tax.
2. B.A flat 20% penaltyThe 10 percent figure is the early-distribution penalty; 20 percent is the mandatory withholding rate on an eligible rollover distribution paid directly to a participant from an employer plan, which is a different rule and not a penalty at all. Borrowing that number here also drops the ordinary income tax that always accompanies a traditional IRA withdrawal.
3. C.No tax or penaltyThis is the treatment of a qualified Roth IRA distribution, not a pre-59 and a half traditional IRA withdrawal. Traditional IRA dollars were never taxed going in, so they are taxed as ordinary income coming out, and the 10 percent penalty applies on top absent a specific exception.
4. D.Only a capital gains taxTempting because the account may have held appreciated securities for years, so capital gains treatment feels natural. Money inside a retirement account loses its capital-gains character entirely: everything distributed from a traditional IRA is ordinary income, and an early withdrawal adds the 10 percent penalty.

Why: Early traditional IRA withdrawals are subject to a 10% penalty plus ordinary income tax (absent an exception).

Contributions to a nonqualified variable annuity are made with:

1. A.Pre-tax dollars; fully taxed laterPre-tax funding with everything taxable on the way out is the qualified annuity, an IRA or a 403(b) contract. The word nonqualified in the stem is the switch: no deduction goes in, so the investor already owns a cost basis and cannot be taxed twice on it.
2. B.Tax-free dollars with tax-free growthThis upgrades tax deferral into a tax exemption. The annuity postpones tax on the earnings while they compound inside the contract, but that liability is deferred rather than forgiven: withdrawn earnings are taxed as ordinary income, with no capital-gains treatment available.
3. C.Employer dollarsEmployer funding points to a group or qualified arrangement, which by definition is not the nonqualified contract described. A nonqualified annuity is bought by an individual with personal after-tax money and carries no employer plan document, no coverage rules, and no statutory deferral limit.
4. D.After-tax dollars; only earnings are taxed at withdrawalCorrect - basis is not taxed again.

Why: Nonqualified annuity contributions are after-tax; only the earnings are taxed (as ordinary income) at withdrawal.

A non-annuitized withdrawal of gains from a variable annuity is taxed:

1. A.FIFO, with tax-free principal firstFIFO ordering is how a nonqualified annuity would be taxed if the same rules governed it as a brokerage account, and it is intuitive because principal went in first. Congress deliberately reversed the order for annuities to discourage using them as short-term tax shelters, so earnings are deemed withdrawn first.
2. B.LIFO, with taxable earnings coming out firstCorrect - earnings-first (LIFO) taxation.
3. C.Tax-freeTax-free applies to the return of the owner's own after-tax cost basis, which is the last money out rather than the first. The gains portion has never been taxed, so it cannot escape tax on the way out; only the principal layer comes back untaxed once the earnings are exhausted.
4. D.As a long-term capital gainThis is the most defensible wrong answer, since the same securities held directly for years would produce long-term gains at preferential rates. Wrapping them in an annuity trades that rate treatment for deferral: everything taxable that comes out of the contract is ordinary income, no matter how long it was held or what generated it.

Why: Withdrawals are taxed LIFO - earnings (gains) come out first and are taxed as ordinary income before any return of principal.