Distributions from a qualified annuity (for example, one funded through a qualified retirement plan with pre-tax dollars) are generally taxed as:

Why B is correct

With a qualified annuity, the contributions were made with pre-tax dollars and the owner did not have an after-tax investment in the contract (cost basis). Because there is no basis to recover, the exclusion ratio does not shelter any portion of the payments, and each distribution is fully taxable as ordinary income. This differs from a nonqualified annuity, where after-tax premiums create a basis that is recovered through the exclusion ratio. The distinction between qualified and nonqualified annuity taxation is a core exam concept.

Why the other options are wrong

• A) The exclusion ratio applies to nonqualified annuities with an after-tax basis; a qualified annuity has no such basis, so payments are fully taxable. No basis means no shelter for the payments.
• C) Lifetime payment status does not make qualified annuity payments tax-free; the absence of an after-tax basis makes the entire payment taxable. The payment form changes nothing. Full taxation is the result.
• D) Annuity payments from a qualified contract are ordinary income, not capital gains, and the full amount of each payment is taxed. Ordinary income is the rule. There is no capital gain here.

Memory hook

Pre-tax in means fully taxed out — qualified annuities have no basis to shelter.