How are gains in an annuity treated for tax purposes?

• A. Gains are tax-free
• B. Interest is taxed annually
• C. Gains are taxed at distribution
• D. Contributions are tax-deductible

Answer: (C)

Gains in an annuity grow tax-deferred, so you don’t pay taxes on the earnings as they accumulate inside the contract. Taxes come when you take money out. At withdrawal, the portion of each payout that represents earnings is taxed as ordinary income, while the amount that’s a return of your principal (cost basis) isn’t taxed again. This is why gains are taxed at distribution. If the annuity is funded with pre-tax dollars in a qualified arrangement, the entire distribution is taxed as ordinary income, and if funded with after-tax dollars in a non-qualified annuity, only the earnings portion is taxed. The other statements don’t fit the usual tax treatment of annuities.