Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

In a non-qualified annuity, how is a return of capital taxed?

1. As ordinary income

2. As a capital gain

3. Tax-free

4. As a qualified distribution

The correct answer is: Tax-free

In a non-qualified annuity, the return of capital is treated as tax-free. This is due to the way non-qualified annuities are structured in terms of taxation. When you invest in a non-qualified annuity, you are using after-tax dollars, meaning you have already paid income taxes on the money you are investing. As the annuity generates earnings, those earnings are taxable upon withdrawal, but the portion of the withdrawal that represents a return of your principal (initial investment) is not taxed again. This returns your capital to you tax-free, allowing you to recoup the original investment without additional tax implications. Understanding this distinction is key, as it explains why this approach is beneficial for individuals planning their withdrawals: they can recover their investment without being taxed on it, which can help with overall financial planning and cash flow management. The tax-free treatment applies specifically to the return of capital until the investment has been fully recouped, at which point any further withdrawals would typically be subject to taxation on the earnings.