Key Takeaways
- Annuity earnings grow tax-deferred during accumulation.
- Non-qualified annuity withdrawals use LIFO-earnings taxed first.
- Annuitized payments use the exclusion ratio to determine taxable portion.
- 10% penalty applies to taxable distributions before age 5912.
- Qualified annuities (IRA, 401(k)) are 100% taxable at withdrawal.
- Non-qualified annuities tax only the earnings portion.
- After recovering the investment, 100% of payments become taxable.
- Beneficiaries pay taxes on inherited earnings as ordinary income.
Annuity Taxation
Understanding how annuities are taxed is essential for both the licensing exam and advising clients. The tax treatment varies based on when and how distributions are taken.
Tax-Deferred Growth
During the accumulation phase, annuity earnings grow tax-deferred.
How Tax Deferral Works
| Taxable Account | Annuity |
|---|---|
| Interest taxed annually | No tax until withdrawal |
| Dividends taxed annually | Earnings compound tax-free |
| Realized gains taxed | No current tax on gains |
Benefit of Tax Deferral
Over long periods, tax deferral allows more money to compound:
| Investment | After 20 Years (6% return) |
|---|---|
| Taxable account (25% tax) | ~$262,000 |
| Tax-deferred annuity | ~$321,000 |
Assumes $100,000 initial investment.
Taxation of Withdrawals (Non-Qualified Annuities)
For non-qualified annuities (purchased with after-tax dollars), the IRS applies the Last-In, First-Out (LIFO) rule.
LIFO Rule
| Concept | Description |
|---|---|
| LIFO | Earnings (last in) are considered withdrawn first |
| Effect | Withdrawals are taxable until all earnings are withdrawn |
| After earnings | Remaining withdrawals are tax-free return of principal |
Example: LIFO Taxation
| Account Detail | Amount |
|---|---|
| Premiums paid (cost basis) | $100,000 |
| Current account value | $150,000 |
| Earnings (gains) | $50,000 |
If owner withdraws $30,000:
- First $30,000 is from earnings = fully taxable
- Owner would need to withdraw $50,000+ before reaching tax-free principal
LIFO Exception
If the annuity was purchased before August 14, 1982, withdrawals may use FIFO (First-In, First-Out), where principal comes out first.
The Exclusion Ratio
When an annuity is annuitized, a portion of each payment is tax-free (return of principal) and a portion is taxable (earnings). The exclusion ratio determines this split.
Exclusion Ratio Formula
Exclusion Ratio = Investment in Contract ÷ Expected Return
| Component | Definition |
|---|---|
| Investment in contract | Total premiums paid (cost basis) |
| Expected return | Payment amount × Expected number of payments |
Example: Exclusion Ratio Calculation
| Factor | Amount |
|---|---|
| Premiums paid | $200,000 |
| Monthly payment | $1,500 |
| Life expectancy at annuitization | 20 years (240 months) |
| Expected return | $1,500 × 240 = $360,000 |
| Exclusion ratio | $200,000 ÷ $360,000 = 55.56% |
Applying the Exclusion Ratio
Each $1,500 payment:
- Tax-free portion: $1,500 × 55.56% = $833.40
- Taxable portion: $1,500 × 44.44% = $666.60
After Recovering Investment
Once the annuitant has recovered their full investment ($200,000 in this example):
- 100% of each payment becomes taxable
- No more exclusion ratio applies
Exam Tip: The exclusion ratio applies only to annuitized payments, not random withdrawals. Withdrawals use LIFO; annuity payments use the exclusion ratio.
10% Early Withdrawal Penalty
The IRS imposes a 10% penalty on taxable distributions before age 59½.
Penalty Calculation
| Distribution | Calculation |
|---|---|
| Taxable portion | Subject to 10% penalty |
| Non-taxable portion | Not subject to penalty |
Example: Early Withdrawal
Owner age 55 withdraws $20,000 from a non-qualified annuity:
- $20,000 is all earnings (under LIFO)
- Income tax: $20,000 × 25% bracket = $5,000
- 10% penalty: $20,000 × 10% = $2,000
- Total tax cost: $7,000
Exceptions to the 10% Penalty
| Exception | Description |
|---|---|
| Age 59½ or older | No penalty |
| Death | Beneficiary distributions not penalized |
| Disability | Total and permanent disability |
| Substantially equal periodic payments (72(t)) | Series of payments over life expectancy |
| Immediate annuity | Purchased with after-tax dollars, annuitized immediately |
Qualified vs. Non-Qualified Annuities
Annuities can be classified as qualified (inside retirement accounts) or non-qualified (purchased with after-tax dollars).
Key Differences
| Feature | Qualified Annuity | Non-Qualified Annuity |
|---|---|---|
| Funding | Pre-tax dollars (IRA, 401(k)) | After-tax dollars |
| Tax deduction | Contributions may be deductible | No deduction for contributions |
| Taxation at withdrawal | 100% taxable | Only earnings are taxable |
| Required Minimum Distributions | Yes (starting at age 73) | No RMDs during owner's life |
| 10% penalty before 59½ | Yes | Yes (on earnings) |
Qualified Annuity Example
In a qualified annuity (IRA), owner contributed $100,000 pre-tax:
- 100% of withdrawals are taxable
- No cost basis (contributions were tax-deferred)
Non-Qualified Annuity Example
In a non-qualified annuity, owner contributed $100,000 after-tax:
- Only earnings above $100,000 are taxable
- Cost basis ($100,000) is returned tax-free
Death Benefit Taxation
When the annuity owner or annuitant dies, the beneficiary must pay taxes on any earnings.
Tax Treatment for Beneficiaries
| Situation | Tax Treatment |
|---|---|
| Non-spouse beneficiary | Must take distributions; earnings taxed |
| Spouse beneficiary | Can continue contract or take distributions |
| Annuitized payments remaining | Taxed under exclusion ratio |
| Lump sum death benefit | Earnings taxed as ordinary income |
Inherited Annuity Distribution Rules
| Beneficiary Type | Distribution Options |
|---|---|
| Spouse | Continue as owner, annuitize, or take lump sum |
| Non-spouse | Must begin distributions within one year of death |
| Trust | Depends on trust type and beneficiaries |
Key Takeaways
- Annuity earnings grow tax-deferred during accumulation.
- Non-qualified annuity withdrawals use LIFO-earnings taxed first.
- Annuitized payments use the exclusion ratio to determine taxable portion.
- 10% penalty applies to taxable distributions before age 5912.
- Qualified annuities (IRA, 401(k)) are 100% taxable at withdrawal.
- Non-qualified annuities tax only the earnings portion.
- After recovering the investment, 100% of payments become taxable.
- Beneficiaries pay taxes on inherited earnings as ordinary income.
For withdrawals from a non-qualified annuity, the IRS applies which taxation rule?
The exclusion ratio for annuitized payments is calculated as:
A 50-year-old withdraws $10,000 of earnings from their non-qualified annuity. The tax consequence is:
The difference between qualified and non-qualified annuities regarding taxation is that: