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

What portion of the $22,000 withdrawn by Ann will be subject to ordinary income tax?

1. $7,000

2. $15,000

3. $22,000

4. $0

The correct answer is: $7,000

In this scenario, it's crucial to understand the tax implications of withdrawals from a tax-deferred retirement account, such as an IRA or 401(k). When Ann withdraws funds from such an account, the amount subject to ordinary income tax generally consists of the earnings or growth within the account, along with any contributions made that were previously tax-deductible. If we assume that Ann made initial contributions to her retirement account that were made on a pre-tax basis and has since accrued earnings, it is common for the IRS to treat withdrawals as a combination of contributions and earnings. Consequently, when determining the amount that is subject to ordinary income tax upon withdrawal, the IRS uses a "first-in, first-out" (FIFO) method, meaning that the contributions are considered to be withdrawn first, followed by the earnings. In this case, if Ann's total contributions were $15,000 and the total earnings (or growth) on those contributions amount to $7,000, her total account balance before the withdrawal would be $22,000. When she withdraws the entire balance, only the earnings portion—$7,000—would be subject to ordinary income tax, while the $15,000 that consists of her original contributions would not be taxed