8.2 Taxation of Annuities
Key Takeaways
- Annuity earnings grow tax-deferred; only the gain is ever taxable, as ordinary income.
- During payout, the exclusion ratio splits each annuity payment into tax-free basis and taxable gain.
- Pre-annuitization withdrawals from a non-qualified annuity are LIFO (gain first) with a 10% penalty before 59 1/2.
- Annuity gains do not receive a stepped-up basis at the owner's death; the beneficiary owes ordinary income on the gain (IRD).
- Once basis is fully recovered, the entire payment becomes taxable; if the annuitant dies early, unrecovered basis is deductible.
Taxation of Annuities
An annuity is a tax-deferred accumulation vehicle, but its tax rules differ sharply from life insurance. The central distinction the exam tests: life insurance withdrawals from a non-MEC are FIFO, while non-qualified annuity withdrawals are LIFO.
Accumulation Phase
During accumulation, interest and gains grow tax-deferred. Contributions to a non-qualified annuity are made with after-tax dollars, so the owner's basis equals total premiums paid. No 1099 is issued until money is taken out.
A pre-annuitization withdrawal (surrender, partial withdrawal, or living loan) is taxed LIFO — gain comes out first and is taxed as ordinary income. If the owner is under 59 1/2, a 10% federal penalty applies to the taxable portion unless an exception (death, disability, substantially equal periodic payments) applies.
- Withdrawal of gain: ordinary income + possible 10% penalty
- Withdrawal of basis (after gain exhausted): tax-free
- 1035 exchange to another annuity: tax-free, basis carries over
The Exclusion Ratio (Annuitization)
When the contract is annuitized into a stream of income payments, each payment is split into a tax-free return of basis and a taxable earnings portion using the exclusion ratio.
Exclusion Ratio = Investment in the Contract (basis) / Expected Return
Expected Return = Monthly Payment x 12 x Life Expectancy (months/IRS table)
The exclusion ratio percentage of each payment is tax-free; the remainder is taxable ordinary income.
Worked Example: Exclusion Ratio
- Basis (investment in contract): $100,000
- Expected return over life expectancy: $200,000
- Monthly payment: $1,000
Exclusion ratio = $100,000 / $200,000 = 50%.
Each $1,000 payment: $500 tax-free (return of basis) and $500 taxable as ordinary income.
| Event | Tax Result |
|---|---|
| Annuitant lives past life expectancy (basis fully recovered) | 100% of each later payment is taxable |
| Annuitant dies before recovering basis | Unrecovered basis is deductible on the final return |
This "recover basis until exhausted" rule was set by TEFRA-era changes; before 1986 the exclusion ratio applied for life regardless of how long the annuitant lived.
Annuitization Method Affects the Calculation
The exclusion ratio depends on the expected return, which changes with the payout option chosen. A life-only payout uses the annuitant's life expectancy from the IRS table; a period-certain option uses the guaranteed number of payments; a joint-and-survivor option uses a longer combined life expectancy, which lowers the monthly payment and changes how quickly basis is recovered. The same contract therefore produces different taxable fractions depending on the settlement option. The exam may give you basis and expected return and ask only for the tax-free percentage — always compute basis divided by expected return first.
Aggregation and Partial-Withdrawal Traps
Two anti-abuse rules catch test-takers. First, multiple non-qualified deferred annuities issued by the same company to the same owner in the same calendar year are aggregated and treated as one contract for taxing withdrawals, preventing owners from splitting contracts to get more favorable basis recovery. Second, before annuitization the LIFO rule means even a small partial withdrawal is taxed as gain first — there is no pro-rata basis recovery until the contract is annuitized. A 1035 exchange from one annuity to another preserves basis and is not a taxable withdrawal.
Qualified vs. Non-Qualified Annuities
The rules above describe a non-qualified annuity bought with after-tax dollars, where only the gain is taxable. If the annuity instead funds an IRA or qualified plan (a qualified annuity), the contributions were pre-tax, so the entire payout — basis and gain — is ordinary income, and the exclusion ratio does not apply (basis is generally zero). This distinction is examined alongside the retirement-plan material in 8.4.
Death of the Owner: No Step-Up
Unlike most appreciated property, a deferred annuity does not receive a stepped-up basis at the owner's death. The untaxed gain is income in respect of a decedent (IRD) — the beneficiary pays ordinary income tax on the gain just as the owner would have. This is a frequent exam trap because heirs of stocks and real estate DO get a step-up.
A surviving spouse named as beneficiary may elect to continue the contract as the new owner and keep deferring tax; a non-spouse beneficiary must take distributions and pay ordinary income tax on the gain, though the 10% pre-59 1/2 penalty does not apply to death benefits.
Charges and the Free-Look Effect on Taxation
Non-qualified annuities often carry surrender charges during the early contract years. A surrender charge reduces the cash the owner receives but does not change the taxable gain, which is still measured as account value minus basis before the charge is netted. Bonus and market-value-adjusted annuities can complicate the cash figure but not the underlying basis math. On the exam, separate the economics (what the owner nets after charges) from the tax (gain over basis), because a distractor will blend the two.
Quick Comparison
| Feature | Non-Qualified Annuity | Life Insurance (non-MEC) |
|---|---|---|
| Withdrawal ordering | LIFO (gain first) | FIFO (basis first) |
| Gain taxed as | Ordinary income | Ordinary income |
| 10% pre-59 1/2 penalty | Yes | No |
| Death benefit to beneficiary | Gain taxable (IRD) | Tax-free |
| Step-up at death | No | N/A (tax-free anyway) |
Key Takeaways
- Annuity gains are always ordinary income, never capital gain.
- Pre-annuitization withdrawals are LIFO with a 10% penalty before 59 1/2.
- The exclusion ratio (basis / expected return) sets the tax-free portion of each annuitized payment.
- After basis is recovered, payments are fully taxable; early death allows a deduction for unrecovered basis.
- Annuity gains are IRD at death with no step-up — heirs owe ordinary income tax.
A 50-year-old surrenders a non-qualified deferred annuity. He paid $60,000 in premiums and the account is worth $90,000. What is the federal tax result on the $30,000 gain?
An annuitant has basis of $80,000 and an expected return of $160,000, receiving $800 per month. How much of each payment is taxable?