Annuity Taxation

Understanding the tax treatment of annuities is essential for the Series 7 exam. Key concepts include tax-deferred growth, LIFO taxation, the 10% early withdrawal penalty, and 1035 exchanges.

Tax-Deferred Growth

Annuities offer tax-deferred growth during the accumulation phase:

• Premiums are paid with after-tax dollars (non-qualified annuities)
• Earnings grow without current taxation
• Taxes due only when withdrawn
• No contribution limits (unlike IRAs and 401(k)s)

Qualified vs. Non-Qualified Annuities

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LIFO Taxation Rule

Non-qualified annuity withdrawals follow LIFO (Last-In, First-Out) taxation:

How LIFO Works

• Earnings come out first (taxable as ordinary income)
• Principal comes out last (return of cost basis, not taxable)
• Applies to all partial withdrawals before annuitization

Example:

• Total contract value: $100,000
• Cost basis (premiums paid): $60,000
• Earnings: $40,000

If investor withdraws $25,000:

• First $25,000 is considered earnings (fully taxable)
• Remaining $15,000 earnings + $60,000 basis stays in contract

Exclusion Ratio (During Annuitization)

Once annuitized, each payment has a taxable and non-taxable portion:

Exclusion Ratio = Investment (Cost Basis) ÷ Expected Return

The exclusion ratio determines what percentage of each payment is a tax-free return of principal.

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10% Early Withdrawal Penalty

Withdrawals before age 59½ are subject to:

• Regular income tax on earnings
• Plus 10% IRS penalty on taxable portion

Exceptions to the 10% Penalty

Note: The penalty applies to both qualified and non-qualified annuities.

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1035 Exchange

IRC Section 1035 allows tax-free exchanges between certain insurance products:

Permitted 1035 Exchanges

Rules for 1035 Exchanges

• Must be direct transfer between insurance companies
• Same owner and annuitant required
• No cash can touch the policyholder's hands
• Cost basis carries over to new contract
• Surrender charges may still apply on old contract

What is NOT Allowed

• Annuity to life insurance (cannot go "up")
• Taking cash from old policy (taxable event)
• Changing owner or annuitant

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Surrender Charges

Most variable annuities impose surrender charges (CDSC):

• Apply during early years (typically 6-8 years)
• Decline over time (e.g., 7%, 6%, 5%, 4%, 3%, 2%, 1%, 0%)
• "Free withdrawal" provision often allows 10% annually without charge
• Separate from IRS 10% penalty

Important: Surrender charges are a contract fee. The 10% IRS penalty is a tax penalty. Both may apply to early withdrawals.

Warning: Double Penalty Investors under 59½ who withdraw from a variable annuity may face BOTH a surrender charge (from the insurance company) AND a 10% IRS penalty (plus income tax). Make sure clients understand this before purchasing.