8.2 Taxation of Annuities

Taxation of Annuities

Annuities are accumulation and payout vehicles, and the exam tests two phases: the accumulation phase (money grows) and the annuitization/payout phase (money is distributed). The recurring theme is tax deferral during accumulation followed by ordinary-income taxation of gain when money comes out.

Accumulation phase

Inside a nonqualified annuity, interest and earnings accumulate tax-deferred — no annual 1099 on internal growth. Contributions to a nonqualified annuity are made with after-tax dollars, so the contributions form the cost basis. Contributions to a qualified annuity (e.g., inside an IRA) may be pre-tax, so the entire payout can be taxable.

Withdrawals before annuitization

Nonqualified annuity surrenders and partial withdrawals are taxed LIFO: the gain (interest) comes out first and is taxed as ordinary income, then the tax-free return of basis. Amounts withdrawn before age 59½ incur a 10% IRS penalty on the taxable portion. This LIFO rule is a frequent trap because life insurance cash value (non-MEC) uses the opposite FIFO ordering.

Annuity gains are always ordinary income, never capital gains — even though some growth was tied to market indices in an indexed annuity or to subaccounts in a variable annuity.

The exclusion ratio (annuitization phase)

When a nonqualified annuity is annuitized, each payment is part tax-free return of basis and part taxable gain. The split is set by the exclusion ratio:

Exclusion ratio = Investment in the contract (cost basis) / Expected total return

The resulting percentage of each payment is excluded (tax-free); the remainder is taxable. Worked example: a client invested $100,000; the expected return over the life-expectancy payout is $200,000. Exclusion ratio = 100,000 / 200,000 = 50%. If monthly payments are $1,000, then $500 is tax-free return of basis and $500 is taxable.

Important rule: once the entire cost basis has been recovered (the annuitant outlives life expectancy), all subsequent payments are fully taxable. If the annuitant dies early with basis remaining, the unrecovered basis is deductible on the final return.

Other annuity tax rules

• Death before annuitization: the beneficiary owes ordinary income tax on the gain; there is no step-up in basis for annuities.
• 1035 exchange: annuity-to-annuity transfers defer gain; surrender charges may still apply contractually.
• Owner-driven vs. annuitant-driven: most contracts pay a death benefit at the owner's death, triggering taxation of gain to the beneficiary.

Qualified vs. nonqualified annuities

The exclusion ratio applies only when the annuity has cost basis — that is, after-tax money was paid in. A qualified annuity held inside an IRA, 403(b), or pension plan is usually funded entirely with pre-tax dollars, so there is no basis and 100% of every payment is taxable. A nonqualified annuity is purchased with after-tax dollars and therefore has basis to recover.

Qualified annuities are also subject to required minimum distributions (RMDs) beginning at age 73, plus the 10% early-distribution penalty before 59½. Nonqualified annuities have no RMDs during the owner's life — a frequently tested contrast — though the carrier may impose a maturity date by contract.

Payout options and their tax interaction

Annuitization options drive how long basis is recovered and therefore the exclusion ratio's expected return:

• Straight life (life only): largest payment; pays only while the annuitant lives; nothing to beneficiaries.
• Life with period certain: guarantees payments for a minimum period (e.g., 10 or 20 years) even if the annuitant dies early.
• Life with refund (cash/installment): guarantees at least the premium is returned.
• Joint and survivor: continues (often at 50%–100%) to a survivor.

For each, the expected return is computed from IRS life-expectancy tables and the guarantee, which sets the exclusion ratio. A pure life-only option produces the highest monthly check because the insurer assumes no post-death obligation — the trade-off the exam loves to test against the safety of a period-certain or refund option.

Aggregation, partial annuitization, and 1099-R

Under the annuity aggregation rule, multiple nonqualified deferred annuities issued by the same company in the same calendar year are treated as one contract for taxing withdrawals, preventing owners from spreading withdrawals to dodge the LIFO gain-first rule.

A partial annuitization (annuitizing part of a contract while leaving the rest deferred) gets its own exclusion ratio on the annuitized portion. Carriers report taxable distributions on Form 1099-R. Remember: gains are ordinary income regardless of the product wrapper, so even a variable annuity whose subaccounts produced long-term equity growth is taxed at ordinary rates on distribution — the tax-deferral benefit is paid for by losing capital-gains rates.

One more exam staple: surrender charges are a contractual deduction by the insurer, not a tax. They typically decline over a surrender period (e.g., 7%, 6%, 5% and so on) and stop after the period ends. Do not confuse a surrender charge with the 10% IRS penalty — the charge applies regardless of age, while the penalty applies only to taxable amounts taken before 59½. A withdrawal can trigger both, neither, or just one.