South Carolina Insurance Practice Exam

When a qualified plan starts making payments, which portion of the distributions is taxable?

1. Contributions

2. Gains

3. Dividends

4. Interest

The correct answer is: Gains

When a qualified retirement plan begins making payments to the participant, the portion of those distributions that is taxable primarily includes the gains that have accrued within the account. This is because contributions made to qualified plans, such as 401(k)s or IRAs, are typically either made with pre-tax dollars, meaning taxes will be owed on the principal and any earnings when the funds are withdrawn, or with after-tax dollars (as in the case of Roth accounts), where the contributions have already been taxed. The earnings portion, referred to as gains, results from investment income and capital appreciation realized by the assets held in the account over time. When the plan makes distributions during retirement, only the earnings that were not taxed previously are subject to income tax. Thus, any portion of the withdrawal that represents growth or gains since the contributions were made will be taxable. Contributions would not be taxed if they were made on a pre-tax basis, while dividends and interest generally represent specific forms of income that may or may not be applicable depending on how the account is structured and the investments it holds. In the context of distributions from a qualified plan, it is the gains that are particularly highlighted as the taxable component, underscoring the importance of understanding how retirement accounts accrue and distribute