Final answer:
Tax liability on capital gains and investment income in a variable annuity contract is deferred until withdrawals are made, paralleling a Traditional IRA's tax treatment. These earnings grow tax-deferred within the annuity, and taxes are paid as ordinary income upon withdrawal.
Step-by-step explanation:
During the accumulation period of a variable annuity contract, tax liability on capital gains and investment income is treated as deferred until withdrawals are made. This means that any capital gains or investment income earned within the annuity grow tax-deferred, and the policyholder does not pay tax on these earnings each year as they would with a standard taxable investment account. Instead, taxes on these earnings are paid upon withdrawal, at which point they are typically taxed as ordinary income.
This tax treatment is similar to that of a Traditional IRA, where taxes on contributions and any investment gains are deferred until the policyholder makes withdrawals from the account. Like 401(k)s offered by many employers, which also enjoy this special tax status, variable annuities allow for funds to compound over time without the impact of annual taxes, potentially leading to more significant account growth.
It's vital to remember that unlike the Roth IRA, which offers tax-free growth, with variable annuities and Traditional IRAs, taxes are eventually paid but deferred until the retirement phase when withdrawals are made and could presumably be at a lower tax bracket.