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

Taxation of Annuities

Annuities grow tax-deferred during accumulation, but how distributions are taxed depends on whether you annuitize (covered by the exclusion ratio in 10.1) or take non-annuitized withdrawals/surrenders (covered here). The single most-tested annuity tax rule is LIFO.

Nonqualified annuity withdrawals are taxed LIFO

For a nonqualified deferred annuity (bought with after-tax dollars), partial withdrawals and surrenders follow LIFO—Last In, First Out. Because interest/earnings are treated as accumulating on top of your principal, the IRS deems that the earnings (gain) come out first and are fully taxable as ordinary income. Only after all gain is withdrawn do you reach your tax-free basis.

Contrast this with life insurance withdrawals, which generally use FIFO (basis out first). This LIFO-versus-FIFO distinction is a classic exam trap.

Worked surrender example

Dan owns a nonqualified deferred annuity with a $120,000 cash value. He paid $80,000 in premiums (basis), so the gain is $40,000.

• He withdraws $30,000. Under LIFO, the first dollars out are earnings—all $30,000 is taxable ordinary income (it is within the $40,000 of gain).
• If instead he fully surrenders for $120,000, the $40,000 gain is taxable and the $80,000 basis is returned tax-free.

The 10% premature-distribution penalty

Distributions of taxable gain before age 59½ generally carry a 10% IRS penalty on the taxable portion (in addition to ordinary income tax). In Dan's $30,000 withdrawal, if he is under 59½, he owes income tax on $30,000 plus a $3,000 penalty. Exceptions to the penalty include death, disability, and substantially equal periodic payments.

Annuity death (owner dies before annuitization)

Gain in a deferred annuity is income in respect of a decedent (IRD)—the beneficiary pays ordinary income tax on the gain. There is no step-up in basis for annuity gain, unlike many other inherited assets.

Section 1035 exchanges (tax-free swaps)

IRC Section 1035 lets a policyowner exchange certain insurance/annuity contracts without triggering current income tax on the gain. The contract must be exchanged directly insurer-to-insurer—if the owner takes cash first, it is a taxable distribution.

Permitted 1035 exchange directions (think of it as a one-way "down the risk ladder"):

Key trap: You can go from life to annuity, but never from annuity to life insurance, because that would convert taxable annuity gain into a tax-free death benefit. The same insured/annuitant must generally be on both contracts, and the cost basis carries over to the new contract.

Qualified vs. nonqualified annuities and RMDs

• A nonqualified annuity is funded with after-tax dollars; only the gain is taxable on distribution (LIFO).
• A qualified annuity (inside an IRA or employer plan) is funded with pre-tax dollars; the entire distribution is taxable because no basis was created.

Required Minimum Distributions (RMDs): Qualified annuities and IRAs require the owner to begin taking RMDs at the current beginning age (age 73 under the SECURE 2.0 Act for those who reach 72 after 2022). Nonqualified annuities are not subject to RMDs.

Quick RMD illustration: If an account is worth $500,000 and the IRS life-expectancy factor is 25, the RMD = $500,000 ÷ 25 = $20,000 for that year. Missing an RMD historically triggered a steep excise tax (reduced under SECURE 2.0), so the exam stresses that qualified-money distributions cannot be deferred indefinitely.

LIFO Withdrawals and the 10% Penalty

Nonqualified annuity earnings grow tax-deferred, but the order of taxation on withdrawals is LIFO (last-in, first-out): the interest/gain comes out first and is fully taxable as ordinary income, then the tax-free return of principal.

• Worked example: An owner deposits $50,000 that grows to $70,000 and withdraws $15,000. Because gain ($20,000) is deemed withdrawn first, all $15,000 is taxable ordinary income.
• A 10% IRS penalty applies to the taxable portion of withdrawals taken before age 59½, on top of ordinary income tax.

Contrast this with life insurance cash-value withdrawals (non-MEC), which are FIFO — basis first, so partial withdrawals up to basis are tax-free.

1035 Exchanges and Annuitization Taxation

IRC Section 1035 lets an owner exchange one contract for another without current tax on the gain, preserving cost basis. Permitted directions:

The rule flows one way toward annuities; you cannot 1035 an annuity into life insurance. When the contract is annuitized, taxation shifts to the exclusion ratio method: each payment is part tax-free return of basis and part taxable gain, until basis is fully recovered, after which payments are fully taxable.