10.3 Taxation of Annuities (LIFO, surrender, 1035 exchanges)

Tax-Deferred Accumulation

During an annuity's accumulation phase, earnings grow tax-deferred: interest and gains are not taxed until they are withdrawn. Compared with a taxable account, deferral lets earnings compound on dollars that would otherwise have been paid in tax each year.

There is no income tax deduction for premiums paid into a non-qualified annuity, because they are after-tax dollars. The cost basis equals total premiums paid.

The LIFO Rule on Withdrawals

For a non-qualified annuity, pre-annuitization withdrawals are taxed under Last-In, First-Out (LIFO). Earnings (the "last in") are treated as withdrawn first and are fully taxable as ordinary income; only after all gain is taxed does the tax-free return of basis begin.

LIFO Example

If the owner withdraws 30,000 dollars:

• All 30,000 dollars is deemed to come from the 60,000 dollar gain = fully taxable.
• The owner would have to withdraw more than 60,000 dollars before any tax-free principal is returned.

Exam contrast: Withdrawals use LIFO; annuitized payments use the exclusion ratio (10.1). Pre-August 14, 1982 contracts may instead use FIFO.

The 10 Percent Early-Distribution Penalty

A taxable distribution taken before age 59 1/2 is generally subject to a 10 percent IRS penalty on the taxable amount (this is in addition to ordinary income tax). The penalty applies only to the taxable portion, never to tax-free return of basis.

Penalty Example

An owner age 54 withdraws 20,000 dollars of pure gain from a non-qualified annuity (25 percent bracket):

Common exceptions to the penalty: owner reaches age 59 1/2, becomes disabled, dies (paid to beneficiary), or takes substantially equal periodic payments. Annuitization payouts that meet the rules also avoid the penalty.

Qualified Annuities and Required Minimum Distributions

A qualified annuity is funded with pre-tax dollars (for example, inside an IRA or a 403(b)). Because no tax was paid on contributions, the entire distribution is taxable as ordinary income (there is no tax-free basis to exclude).

Qualified annuities are subject to Required Minimum Distributions (RMDs) beginning at age 73 under current law. Failing to take an RMD triggers a steep IRS excise tax on the shortfall.

Section 1035 Exchanges

Internal Revenue Code Section 1035 lets a policyowner exchange one contract for another without recognizing gain, preserving cost basis and tax deferral. The exchange must be a direct transfer between insurers, not a cash-out and repurchase.

Permitted Directions

Trap / memory hook: You can move "down" from life insurance to an annuity tax-free, but you can NEVER move "up" from an annuity to life insurance under 1035. Also, a 1035 exchange does not erase MEC status, and it does not reset the cost basis.

Annuitized Payments and the Exclusion Ratio

Once a non-qualified annuity is annuitized, each income payment is split into a tax-free return of cost basis and a taxable earnings portion, using the exclusion ratio:

Exclusion ratio = Investment in the contract / Expected total return

Worked example: $100,000 basis, expected lifetime return $200,000. Ratio = 100,000 / 200,000 = 50%. On each $1,000 monthly payment, $500 is tax-free and $500 is taxable. Once the entire basis has been recovered (the insured outlives life expectancy), all future payments become fully taxable.

1035 Exchange Rules and Pitfalls

IRC Section 1035 lets an owner exchange one annuity (or life policy) for another without recognizing gain, preserving cost basis and deferral. The valid, tax-free directions are limited:

An annuity cannot be exchanged into a life insurance policy tax-free that is the classic exam trap. The contracts must be on the same insured/annuitant, and any cash taken out ("boot") is taxable.

Exam Tip: You can roll life-to-annuity but never annuity-to-life under 1035. Remember the gain in an annuity is always LIFO (taxed first) on non-annuitized withdrawals.

Death of the Owner Before Annuitization

If a deferred annuity owner dies during the accumulation phase, the gain has never been taxed, so the beneficiary owes income tax on the gain (there is no step-up in basis as there is for some other assets). The death benefit equals at least the account value (or premiums paid, depending on the contract).

Non-natural owners (corporations, most trusts) generally lose tax deferral annual gains are taxed currently because deferral is reserved for arrangements benefiting a natural person.

Exam Tip: Annuity gains are always ordinary income (never capital gains), there is no step-up at death, and non-natural owners usually forfeit deferral. The exclusion ratio applies only to annuitized payments; lump-sum withdrawals are LIFO.