How are taxes on earnings inside a variable annuity treated?

• A. Withdrawals are tax-free regardless of timing.
• B. Earnings are taxed at capital gains rates upon withdrawal.
• C. Taxes are paid on withdrawals or annuitization, and earnings are taxed as ordinary income; a 10% penalty may apply to withdrawals before age 59½.
• D. Taxes are paid on the entire contract value at purchase.

Answer: (D)

Earnings inside a variable annuity grow tax-deferred, so you don’t pay taxes as the account earns money. Taxes arrive when you take money out—either as withdrawals or when you begin annuitization. At that point, the portion of the withdrawal that represents earnings is taxed as ordinary income (not at capital gains rates), while the portion that represents your original contributions, or basis, is generally returned tax-free. If you withdraw before age 59½, a 10% early-withdrawal penalty typically applies to the taxable portion. This is why the tax treatment hinges on withdrawals or annuitization, not on paying taxes at the time of purchase or on the entire contract value upfront.