8.2 Taxation of Annuities

Taxation of Annuities

Annuities are the mirror image of life insurance for tax purposes: contributions grow tax-deferred, but eventually nearly all the gain is taxed as ordinary income — never capital gain. The exam tests the accumulation phase, withdrawals, the annuitization exclusion ratio, penalties, and death-benefit treatment.

Accumulation Phase

Inside a deferred annuity, interest, dividends, and capital gains accumulate without current taxation. There is no annual 1099 while the contract grows. This deferral is the annuity's central tax advantage.

Cost basis in a non-qualified annuity equals the after-tax premiums contributed. In a qualified annuity (funded with pre-tax dollars, e.g., a traditional IRA annuity), basis is generally zero, so the entire distribution is taxable.

Withdrawals Before Annuitization — LIFO

For non-qualified annuities purchased after August 13, 1982, partial withdrawals are taxed LIFO: gain (interest) comes out first and is fully taxable as ordinary income, then return of basis is tax-free.

• Example: A non-qualified annuity holds $90,000 ($60,000 basis + $30,000 gain). A $20,000 withdrawal is entirely taxable because the first $30,000 out is gain.

The 10% Premature Distribution Penalty

A 10% IRS penalty applies to the taxable portion of distributions taken before age 59½, on top of ordinary income tax. Exceptions include death, disability, and substantially equal periodic payments (72(t)).

Annuitization and the Exclusion Ratio

When the contract is annuitized (converted to 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 ÷ Expected Total Return

The portion of each payment equal to the exclusion ratio is tax-free; the remainder is ordinary income.

Worked Example

• Investment in the contract (basis): $100,000
• Monthly payment: $1,000 → $12,000/year
• Expected return (life expectancy 20 years): $12,000 × 20 = $240,000
• Exclusion ratio = $100,000 ÷ $240,000 = 41.67%
• Tax-free per payment = $1,000 × 41.67% = $416.70; taxable = $583.30

Key trap: Once the annuitant has recovered the entire basis (here, after 20 years / age past life expectancy), all subsequent payments are 100% taxable. Conversely, if the annuitant dies before recovering basis, the unrecovered amount is a deduction on the final return.

Death and Other Rules

Annuity death benefits do not receive the income-tax exclusion that life insurance enjoys, and there is no step-up in basis — a frequently tested distinction.

Qualified Annuities, Penalties, and Common Traps

Qualified vs. Non-Qualified Annuities

A non-qualified annuity is bought with after-tax dollars, so only the gain is taxable on distribution (LIFO). A qualified annuity (funding an IRA, 403(b), or pension) is bought with pre-tax dollars, so the entire distribution — principal and gain — is ordinary income, and RMDs apply at age 73.

The 10% Penalty and Its Exceptions

The 10% premature-distribution penalty hits the taxable portion of withdrawals before age 59½. Exam-tested exceptions:

• Death or disability of the owner
• A series of substantially equal periodic payments (IRC 72(t))
• Annuitization over the owner's life expectancy

Accumulation vs. Annuity Phase Recap

• Accumulation (deferral) phase: money grows tax-deferred; withdrawals are LIFO.
• Annuity (payout) phase: the exclusion ratio applies; once basis is recovered, payments are fully taxable.

Worked Penalty Example

A 54-year-old surrenders a non-qualified annuity worth $70,000 with $25,000 of gain. The $25,000 gain is ordinary income, plus a 10% penalty of $2,500. The $45,000 of basis is returned tax-free. Total adverse tax impact: $25,000 taxed + $2,500 penalty.

Trap: Annuities never produce capital-gain treatment, and the death benefit gets no step-up in basis — a beneficiary inherits the owner's gain and pays ordinary income tax on it. This is the opposite of inheriting appreciated stock.

LIFO, the Exclusion Ratio, and Premature Distribution Penalty

Annuity earnings grow tax-deferred, but the tax treatment of withdrawals depends on whether the annuity is qualified or non-qualified and whether it is annuitized.

• Non-annuitized withdrawals from a non-qualified annuity are taxed LIFO (last-in, first-out) — earnings come out first and are fully taxable as ordinary income; only after all gain is withdrawn does the tax-free return of basis begin. (Contracts issued before 8/14/1982 use the more favorable FIFO order.)
• Annuitized payments use the exclusion ratio = cost basis ÷ expected return; the basis portion is tax-free until fully recovered, after which 100% is taxable.

A 10% IRS penalty applies to the taxable portion of distributions taken before age 59½, on top of ordinary income tax — mirroring the qualified-plan early-withdrawal penalty. Exceptions include death, disability, and a series of substantially equal periodic payments (72(t)).

Worked LIFO Example

An owner deposited $50,000 into a non-qualified deferred annuity now worth $80,000 (so $30,000 is gain). A $20,000 withdrawal is treated as all earnings under LIFO → the full $20,000 is taxable as ordinary income, and if the owner is under 59½, a $2,000 (10%) penalty applies on top. No basis comes out until the entire $30,000 of gain has been withdrawn.

Qualified Annuities and Estate Treatment

In a qualified annuity (funded with pre-tax dollars inside an IRA/403(b)/pension), there is no separate basis — essentially all distributions are taxable, and RMDs at age 73 apply. Annuity gains are always ordinary income, never capital gains, even though the underlying separate-account subaccounts hold equities — a recurring exam trap. At death, any gain in a non-qualified annuity is income in respect of a decedent (IRD), taxable to the beneficiary; there is no step-up in basis as there would be for an inherited capital asset.