What tax treatment do distributions from a non-qualified variable annuity face?

The tax treatment of distributions from a non-qualified variable annuity involves considering the original contributions made to the annuity and the earnings generated over time. In this case, the correct answer highlights that there is tax liability only on the amount above the original contributions.

When distributions are taken from a non-qualified variable annuity, the original contributions made to the annuity are considered the principal or basis, which has already been taxed. Therefore, when a withdrawal occurs, the Internal Revenue Service (IRS) allows the account holder to take out their original contributions tax-free. However, any amount withdrawn that exceeds the total contributions represents earnings or growth that has not yet been taxed, and this is where the tax liability arises.

This taxation approach is often referred to as the "last in, first out" (LIFO) method, wherein the gains are treated as being withdrawn first, thus subject to income tax. Consequently, the correct answer correctly identifies that only the earnings portion (the amount above the original contribution) is taxable upon withdrawal. This distinction is essential for understanding how tax implications can affect the planning and timing of withdrawals from a non-qualified variable annuity.