South Carolina Life Insurance Practice Exam

What type of annuity activity triggers immediate taxation of the interest earned?

1. Rolling over the annuity

2. Surrendering the annuity for cash

3. Purchasing with after-tax dollars

4. Converting to a life insurance policy

The correct answer is: Surrendering the annuity for cash

When an individual surrenders an annuity for cash, it results in immediate taxation on any interest earned. This is because the cash value of the annuity includes both the principal (the amount invested) and the accumulated interest. The IRS treats the interest as taxable income upon withdrawal. Therefore, if the total amount surrendered exceeds the original investment (the principal), the excess—representing the interest—will be subject to income tax in the year of the withdrawal. In contrast, rolling over the annuity does not trigger immediate taxation, as the funds are transferred directly to another tax-deferred account without any distribution. Purchasing an annuity with after-tax dollars means that the initial investment has already been taxed, so the subsequent account value grows tax-deferred and will only be taxed upon withdrawal. Converting an annuity to a life insurance policy also does not create a taxable event, as the exchange is typically considered a tax-free exchange under IRS rules. Thus, surrendering the annuity is the only activity listed that directly results in immediate taxation on the interest earned.