This is a prime example of a situation in which you should carefully review your tax forms and consult with a CPA or your tax advisor to figure out where you stand based on your specific situation. I don't have all the information to provide a definitive answer, but here are some questions to consider as you dig a little deeper:
Was the annuity inside or outside an IRA? This can result in substantially different tax treatment. For example, in a situation like you described, only the earnings on an annuity outside of an IRA or retirement plan, a non-qualified annuity, would be taxable and subject to the 10% premature withdrawal penalty. So, if this was the case and your wife contributed $3,000 of after-tax money to the non-qualified annuity, only $1,000 would be subject to taxes and the penalty. Additionally, most withdrawals from IRAs can be rolled over to another IRA as long as it happens within 60 days--so, if it was an IRA, you may have the ability to limit the tax impact by replacing some (or all) of the withdrawal by making a rollover contribution if you're still in that window.
IRAs have special exceptions to 10% rule. A little different angle on the same topic, but certain pre-59 1/2 distributions from an IRA are not subject to the additional 10% tax discussed above. For example, a distribution to buy or build your first home would not result in the 10% penalty. Check out IRS Publication 590-B for all the details. While there are exceptions that will allow you to avoid the 10% penalty on non-qualified annuity withdrawals, there's not one similar to the first time home buyer exception I used as a potentially applicable rule.
Annuity rules can be complex. Rules can vary based on when the annuity was purchased, how it was set up (ownership, etc.) and how the withdrawal(s) are made. Again, another reason to seek assistance.
Tax brackets are progressive. If you're subject to a 10% penalty, that could mean up to $400 in taxes, but the good news when it comes to our tax system and your situation is that as you make your way through the tax brackets (10%, 15%, 25%, etc.) you only pay the highest figure or tax on the income that falls into that bracket. For example, if the extra income pushes you $2,000 into the 25% tax bracket, only that $2,000 would be subject to the higher rate, not the rest of your income.
Hopefully, this information helps get you pointed in the right direction...towards your tax advisor! Good luck.
JJ
