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

Taxation of Annuities

Nonqualified annuities grow tax-deferred during accumulation; no tax is due until money comes out. How it comes out determines the tax. The two main exit paths are annuitization (covered by the exclusion ratio in 10.1) and non-annuity distributions — withdrawals, surrenders, and loans — which follow LIFO rules.

LIFO (Last-In, First-Out): For nonqualified annuities issued after August 13, 1982, the IRS treats withdrawals as coming from earnings first. Because gains are deemed withdrawn before basis, early withdrawals are fully taxable as ordinary income until all gain is exhausted.

Withdrawals, surrender, and the 10% penalty

• Partial withdrawal: Taxable as ordinary income to the extent of gain (LIFO).
• Full surrender: Owner receives cash value minus surrender charges; the amount exceeding basis is taxable ordinary income — not capital gain.
• 10% premature-distribution penalty: Applies to the taxable portion if taken before age 59½, unless an exception (death, disability, substantially equal periodic payments) applies.

Worked example: An annuity with $50,000 basis has grown to $80,000 ($30,000 gain). A $20,000 withdrawal at age 50 is entirely gain under LIFO — all $20,000 is ordinary income, plus a 10% penalty ($2,000).

Comparison of distribution methods

Trap: Annuity gains are always ordinary income, never long-term capital gain — students wrongly expect favorable capital-gains rates. Also note nonqualified annuities have no Required Minimum Distribution (RMD) based on age 73; only qualified annuities/plans require RMDs.

Qualified annuities and RMDs

In a qualified annuity (funded with pre-tax dollars inside an IRA or employer plan), there is no basis — the entire distribution is taxable ordinary income. These are subject to Required Minimum Distributions (RMDs) beginning at age 73 (per the SECURE 2.0 Act). Failing to take an RMD triggers an excise tax on the shortfall.

RMD mechanics: RMD = prior-year-end account balance ÷ IRS life-expectancy distribution period. Example: a $400,000 IRA balance with a distribution period of 25.0 yields an RMD of $16,000 for the year. Roth IRAs have no lifetime RMD for the original owner.

Section 1035 exchanges

IRC Section 1035 lets an owner exchange one contract for another without recognizing gain, preserving tax deferral. The permitted directions follow a one-way ladder:

• Life insurance → life insurance, endowment, annuity, or long-term care — allowed
• Annuity → annuity or long-term care — allowed
• Annuity → life insurance — NOT allowed (you cannot go back up the ladder)

Rules and traps:

• The exchange must be insurer-to-insurer; taking cash personally breaks the tax-free status.
• The owner and insured/annuitant must remain the same.
• Basis carries over to the new contract.
• A MEC stays a MEC through a 1035 exchange; the taint cannot be washed out.

Annuitant death, beneficiary taxation, and the aggregation rule

If the owner dies during accumulation, the contract value must be distributed; gain is taxable to the beneficiary as income in respect of a decedent (IRD) — there is no step-up in basis for annuities. A surviving spouse may elect spousal continuation and keep the contract deferred. Nonspouse beneficiaries generally take proceeds within five years or stretch them over their own life expectancy.

The IRS also applies an aggregation rule: multiple nonqualified deferred annuities issued by the same insurer to the same owner in the same calendar year are treated as one contract when computing the taxable portion of a withdrawal. This blocks owners from splitting purchases to dodge the LIFO calculation.

Loans and assignments are taxable. Taking a loan from a nonqualified annuity, or pledging it as collateral, is treated as a distribution subject to LIFO and the pre-59½ penalty — unlike life insurance, where a policy loan is generally tax-free.

Nonqualified vs. qualified at a glance

Exam tip: The most-tested distinction is basis. A nonqualified owner already paid tax on premiums, so only earnings are taxed on the way out. A qualified annuity used untaxed dollars, so 100% of every distribution is ordinary income. Combine that with LIFO (gains first) and the one-way 1035 ladder and you can answer most annuity-tax items.