10.3 Taxation of Annuities (LIFO, Surrender, 1035 Exchanges)

Tax-Deferred, Not Tax-Free

A nonqualified annuity is bought with after-tax dollars, so the premium (basis) is never taxed again. The earnings, however, grow tax-deferred and are eventually taxed as ordinary income - never as tax-free death benefit and never at capital-gains rates.

This is the core contrast with life insurance:

Exam tip: Remember the slogan - life insurance is for dying (tax-free death benefit), annuities are for living (tax-deferred income), and the annuity's deferred gain is taxed when it comes out.

LIFO Treatment of Withdrawals and Surrenders

Before annuitization, money taken from a nonqualified annuity (a partial withdrawal or a full surrender) is taxed under LIFO - Last In, First Out. The IRS treats the most recently credited dollars (the earnings) as coming out first.

• Earnings come out first and are fully taxable as ordinary income.
• Basis comes out last and is tax-free once all gain has been withdrawn.

Worked Example: Partial Withdrawal

Because the $30,000 gain is taxed first, the entire $20,000 withdrawal is taxable. Only after all $30,000 of gain is withdrawn would further withdrawals tap the tax-free basis.

Exam trap: A surrender charge is the insurer's penalty for early termination. The 10% IRS penalty is a separate federal tax penalty. Do not confuse the two.

The 10% Early-Distribution Penalty

If the taxable portion of an annuity distribution is taken before the owner reaches age 59 1/2, the IRS adds a 10% penalty on top of ordinary income tax on that taxable amount.

Common Exceptions to the Penalty

Penalty Example

A 52-year-old withdraws $20,000 of gain from a nonqualified annuity.

Exam tip: The penalty is only on the taxable amount, not on any tax-free return of basis.

Section 1035 Exchanges

A Section 1035 exchange lets a policyowner swap one contract for a similar one without triggering current tax on the gain. The basis and gain carry over to the new contract; only the rules of allowable direction must be followed.

Allowable Tax-Free Directions

The one-way rule is the key trap: you can move from life to an annuity, but never from an annuity to life insurance, because that would convert taxable annuity gain into a tax-free death benefit.

Rules to Keep the Exchange Tax-Free

• The owner and insured/annuitant must remain the same.
• The exchange should be a direct transfer between insurers, not a cash-out followed by repurchase.
• Taking cash ("boot") in the exchange makes that cash taxable to the extent of gain.

Taxation of the Annuity Death Benefit

Unlike life insurance, an annuity has no income-tax-free death benefit. If the owner dies before annuitizing, the beneficiary receives the account value, and the gain (account value minus basis) is taxable to the beneficiary as ordinary income. This is sometimes called income in respect of a decedent (IRD).

Example

The $50,000 of gain is taxed as ordinary income to the beneficiary; the $100,000 of basis is recovered tax-free.

Exam trap: This is why annuities are described as bad assets to leave to heirs compared with life insurance: the heir inherits the embedded taxable gain rather than a tax-free death benefit.

Qualified Annuities and Required Minimum Distributions

The LIFO and exclusion-ratio rules above describe nonqualified annuities bought with after-tax dollars. A qualified annuity funds a tax-qualified plan (such as an IRA or 403(b)) with pre-tax dollars, so the owner has little or no basis. As a result, nearly 100% of every distribution is taxable as ordinary income, not just the gain.

Required Minimum Distributions (RMDs)

Qualified annuities are subject to Required Minimum Distributions. Under current federal rules, the owner must begin taking RMDs by April 1 of the year after turning age 73. Failing to take an RMD triggers a steep IRS excise penalty on the shortfall.

Putting It Together

For the exam, anchor on three rules. First, annuity growth is tax-deferred but the gain is always ordinary income. Second, pre-annuitization withdrawals are LIFO with a 10% penalty before 59 1/2. Third, Section 1035 lets you move tax-free in every direction except annuity-to-life. Layer the qualified-versus-nonqualified distinction on top, and most annuity tax questions become straightforward.