8.2 Taxation of Annuities

Annuities Are the Mirror Image of Life Insurance

Life insurance creates an estate for premature death; an annuity liquidates an estate and protects against living too long (outliving assets). For tax purposes, an annuity is the opposite of life insurance: contributions grow tax-deferred, but distributions are taxed under rules designed to capture the gain.

Qualified vs. Non-Qualified Annuities

A non-qualified annuity is bought with money the owner already paid tax on, so the owner has cost basis equal to total premiums. Only the growth is ever taxable.

Tax-Deferred Accumulation

During the accumulation phase, interest and earnings are not currently taxable. This deferral is the annuity's chief advantage. Note the key limitation: deferral applies only to natural persons who own the contract. If a non-natural person (e.g., a corporation or trust) owns a deferred annuity, the gains are generally taxed currently — an important exam distinction designed to stop businesses from using annuities as a tax shelter.

Qualified Annuities Have Little or No Basis

Because a qualified annuity is funded with pre-tax dollars inside a retirement plan or IRA, the owner usually has zero basis. As a result, virtually the entire distribution is taxable as ordinary income — there is no return-of-basis exclusion. Contributions are capped by IRS plan limits, and required minimum distributions begin at age 73, unlike a non-qualified annuity, which has no lifetime RMD requirement.

Taxation of Distributions

How money comes out depends on whether the contract is annuitized (regular income payments) or surrendered/withdrawn as a lump sum.

Pre-Annuitization Withdrawals: LIFO

For non-qualified annuities issued after August 13, 1982, withdrawals and surrenders use LIFO — the gain (interest) comes out first and is fully taxable as ordinary income. After all gain is withdrawn, the remaining basis comes out tax-free.

10% penalty: Taxable amounts withdrawn before age 59½ carry a 10% IRS penalty unless an exception applies (death, disability, or substantially equal periodic payments).

A subtle wrinkle: the age-59½ penalty applies to the owner's age, not the annuitant's. The penalty stacks on top of ordinary income tax, so an early surrender of a gain-heavy annuity can be expensive. Surrender charges from the insurer (a back-end load that declines over a 5–10 year schedule) are a separate contractual cost, not a tax — students must not confuse the insurer's surrender charge with the IRS 10% penalty.

Worked Example: Surrender

Margaret bought a non-qualified annuity for $75,000; it is now worth $110,000. On a full surrender, the gain is $110,000 − $75,000 = $35,000, taxable as ordinary income. If she is under 59½, add a $3,500 penalty.

Annuitized Payments: The Exclusion Ratio

Once annuitized, each payment is part return of basis (tax-free) and part gain (taxable). The split is set by the exclusion ratio:

Exclusion Ratio = Investment in the Contract ÷ Expected Return

The resulting percentage of each payment is excluded from tax; the rest is taxable ordinary income.

Worked Example: Exclusion Ratio

Robert pays $240,000 for an immediate annuity that will pay $20,000/year for 15 years (expected return $300,000).

• Exclusion ratio = $240,000 ÷ $300,000 = 0.80 (80%)
• Tax-free portion of each $20,000 payment = $16,000
• Taxable portion = $4,000

Trap: Once the owner recovers full basis (lives past life expectancy), all subsequent payments are 100% taxable. If the annuitant dies before recovering basis, the unrecovered amount is deductible on the final return.

1035 Exchanges and Death Benefits

• Section 1035 exchange: A tax-free exchange is allowed life-to-life, life-to-annuity, and annuity-to-annuity, but NOT annuity-to-life (you cannot exchange an annuity for life insurance tax-free). Basis carries over to the new contract. A life or annuity contract may also be exchanged tax-free for a qualified long-term-care policy.
• Death benefit: A non-qualified annuity death benefit is not income-tax-free. The beneficiary owes ordinary income tax on the gain (the amount above basis); the basis portion is tax-free.

Annuitant vs. Owner Death and Spousal Continuation

The parties matter for taxation. On the owner's death during accumulation, the contract must distribute under post-death rules unless a spouse is the beneficiary, in which case the spouse may continue the contract as the new owner and keep deferring. A non-spouse beneficiary generally must take the proceeds within a set period (lump sum, 5-year rule, or annuitization). Remember the LIFO theme: whatever gain remains is taxed as ordinary income to whoever ultimately receives it. There is no step-up in basis for annuities — unlike most other inherited property, the annuity's gain never escapes income tax.

The Exclusion Ratio in the Payout Phase

Once a nonqualified annuity is annuitized, each payment is part tax-free return of cost basis and part taxable earnings, split by the exclusion ratio:

Exclusion ratio = investment in the contract (cost basis) ÷ expected total return.

Worked example: An owner paid $100,000 into a nonqualified annuity and elects a life-with-period-certain payout with an expected return of $200,000. Exclusion ratio = $100,000 ÷ $200,000 = 50%. If the annuity pays $1,000/month, then $500 is a tax-free return of basis and $500 is taxable income each month.

Trap: Once the annuitant has recovered the entire cost basis (lives beyond life expectancy), all further payments are fully taxable. Conversely, if the annuitant dies early, the unrecovered basis is deductible on the final return. Annuitized payments use the exclusion ratio; pre-annuitization withdrawals use LIFO (earnings first, fully taxable).