8.2 Taxation of Annuities

Annuities as Tax-Deferred Accumulation Vehicles

An annuity is the opposite of life insurance: life insurance protects against dying too soon, while an annuity protects against living too long (outliving income). For taxation, the central themes are tax-deferred growth during accumulation and how gains are taxed when money comes out — either through withdrawals or as annuitized income.

Like life insurance, the owner has a cost basis equal to the after-tax premiums paid into a non-qualified annuity. Only the gain above basis is taxable, and it is always taxed as ordinary income — never capital gains.

Qualified vs Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax dollars; the owner has basis, and only the earnings are taxable on distribution. A qualified annuity is funded with pre-tax dollars inside a retirement plan (e.g., a 403(b) or IRA), so the owner usually has zero basis and the entire distribution is taxable as ordinary income.

Both grow tax-deferred. The difference is basis: non-qualified = partly your own money back tax-free; qualified = it was never taxed, so all of it is taxable coming out.

This distinction explains many exam answers. If a question gives you premiums paid into a personal (non-qualified) annuity, you must subtract that basis to find the taxable gain. If the annuity sits inside an IRA or 403(b), assume zero basis and full taxation unless the facts state otherwise.

Pre-Annuitization Withdrawals — LIFO

For non-qualified annuities issued after August 13, 1982 (TEFRA), withdrawals during the accumulation phase are taxed LIFO: gain (interest) is deemed withdrawn first and is fully taxable as ordinary income; only after all gain is exhausted does tax-free basis come out.

A 10% IRS penalty applies to the taxable portion of withdrawals taken before age 59½, mirroring the life-insurance MEC rule. This is why exam questions stress that annuities are long-term retirement vehicles, not short-term savings.

The Exclusion Ratio During Annuitization

Once a contract is annuitized (converted to a stream of income payments), each payment is part tax-free return of basis and part taxable earnings. The portion excluded from tax is set by the exclusion ratio:

Exclusion Ratio = Investment in the Contract ÷ Expected Return

The investment in the contract is the cost basis. The expected return is the periodic payment multiplied by the number of payments expected (based on IRS life-expectancy tables for a life annuity).

Worked Exclusion-Ratio Example

Suppose a non-qualified annuity has a cost basis (investment) of $100,000. It pays $1,000/month for life, and the annuitant's life expectancy from the IRS table is 20 years (240 payments).

• Expected return = $1,000 × 240 = $240,000
• Exclusion ratio = $100,000 ÷ $240,000 = 41.67%
• Tax-free portion of each $1,000 payment = $416.67
• Taxable portion = $583.33 per month

Key trap: once total basis has been recovered (the annuitant outlives the table), all subsequent payments are 100% taxable. If the annuitant dies early, the unrecovered basis is deductible on the final return.

Annuity Tax Summary Table

1035 Exchanges

IRC Section 1035 lets a policyowner exchange one contract for a similar one without recognizing gain. Permitted: life → life, life → annuity, annuity → annuity, and life/annuity → qualified long-term care. Not permitted: annuity → life (you cannot move up to the more tax-favored life contract tax-free). Cost basis carries over to the new contract.

Required Minimum Distributions and Payout Triggers

A qualified annuity inside a retirement plan is subject to required minimum distributions (RMDs) beginning at age 73 under current law — the IRS forces taxable withdrawals so deferral cannot last forever. A non-qualified annuity has no RMD requirement during the owner's lifetime, though contracts have a maximum annuitization age.

When the owner dies before annuitizing, the gain in a non-qualified annuity is income in respect of a decedent (IRD) — taxable to the beneficiary as ordinary income. There is no step-up in basis at death, a frequent contrast with appreciated stock.

Penalty Exceptions and Annuitization Strategy

The 10% pre-59½ penalty on annuity gain has exceptions, including death, disability, and a series of substantially equal periodic payments (SEPP). Annuitizing converts the contract to income and applies the exclusion ratio rather than LIFO, which can reduce current tax versus simply withdrawing the gain.

Key exam point: surrendering a deferred annuity for a lump sum exposes all gain at once as ordinary income, often pushing the owner into a higher bracket. Spreading distributions or annuitizing manages the tax hit — a planning advantage agents should explain.

Death-Phase Taxation and the Lack of a Step-Up

When an annuity owner dies, the contract does not receive a stepped-up basis the way appreciated stock does. The beneficiary owes ordinary income tax on the gain (value above basis) - this is income in respect of a decedent (IRD). The death benefit may be taken as a lump sum, over five years, or stretched over the beneficiary's life expectancy, each spreading the tax differently.

Owner-Driven vs. Annuitant-Driven Contracts

Worked trap: because annuity gains are ordinary income, not capital gain, and there is no step-up, a highly appreciated nonqualified annuity can be a tax-inefficient asset to leave heirs compared with stock. A surviving spouse beneficiary may elect spousal continuation, stepping into the owner's shoes and continuing tax deferral - a key planning point examiners test. Pre-59 1/2 withdrawals still incur the 10% penalty on the taxable (LIFO interest) portion unless an exception applies.