10.3 Taxation of Annuities (LIFO, Surrender, 1035 Exchanges)
Key Takeaways
- Annuities grow tax-deferred; post-1982 non-qualified withdrawals use LIFO, taxing gain first as ordinary income (never capital gain).
- A 10% penalty applies to the taxable portion of distributions before age 59 1/2, with exceptions for death, disability, 72(t), and immediate annuities.
- Qualified annuities are 100% taxable and require RMDs beginning at age 73; non-qualified annuities tax only the gain and have no lifetime RMDs.
- Section 1035 allows tax-free exchanges life-to-life, life-to-annuity, and annuity-to-annuity, but not annuity-to-life, and requires a direct insurer-to-insurer transfer.
- Annuities receive no step-up in basis at death; the beneficiary owes ordinary income tax on the gain.
Taxation of Annuities
Annuities grow tax-deferred during accumulation — no current tax on interest or gains. Tax is triggered only when money leaves the contract. The exam tests three flashpoints: withdrawals (LIFO), surrender, and Section 1035 exchanges, plus the 10% penalty and Required Minimum Distributions (RMDs).
LIFO Taxation of Withdrawals
For non-qualified annuities (after-tax dollars) bought after August 14, 1982, partial withdrawals follow Last-In, First-Out (LIFO): earnings come out first and are fully taxable as ordinary income; only after all gain is withdrawn does tax-free basis return.
| Concept | Effect |
|---|---|
| LIFO | Earnings (last in) deemed withdrawn first |
| Taxable until | All gain is withdrawn |
| Then | Remaining withdrawals are tax-free return of basis |
| Pre-8/14/1982 contracts | Grandfathered to FIFO (basis first) |
LIFO Worked Example
| Detail | Amount |
|---|---|
| Premiums paid (basis) | $80,000 |
| Current account value | $110,000 |
| Gain | $30,000 |
Owner withdraws $25,000:
- Under LIFO, all $25,000 is gain → fully taxable as ordinary income.
- The owner would have to withdraw more than $30,000 before any tax-free principal is reached.
Exam trap: Annuity gains are ordinary income, never capital gains — tax deferral is the trade-off for losing capital-gains rates.
The 10% Early-Distribution Penalty
A 10% federal penalty applies to the taxable portion of distributions taken before age 59 1/2. It is added on top of ordinary income tax. Common exceptions:
- Age 59 1/2 or older
- Death of the owner (beneficiary distributions)
- Total and permanent disability
- Substantially equal periodic payments under IRC Section 72(t)
- Immediate annuity annuitized at purchase
Penalty Example
A 52-year-old withdraws $15,000 of gain from a non-qualified annuity in a 24% bracket:
- Income tax: $15,000 × 24% = $3,600
- Penalty: $15,000 × 10% = $1,500
- Total tax cost: $5,100
A 45-year-old takes a $10,000 partial withdrawal from a non-qualified deferred annuity that has $40,000 of gain over basis. What is the tax treatment?
Qualified vs. Non-Qualified and RMDs
| Feature | Qualified annuity (IRA/401(k)) | Non-qualified annuity |
|---|---|---|
| Funding | Pre-tax dollars | After-tax dollars |
| Cost basis | Usually $0 | Premiums paid |
| Taxation at withdrawal | 100% taxable | Only the gain taxable |
| Required Minimum Distributions | Yes — begin at age 73 | No lifetime RMDs |
RMD basics: A qualified annuity owner must start Required Minimum Distributions (RMDs) by April 1 of the year after turning 73. The RMD equals the prior-year-end balance divided by an IRS life-expectancy factor. Missing an RMD historically triggered a steep excise tax (now 25%, reducible to 10% if corrected promptly).
Section 1035 Exchanges
Internal Revenue Code (IRC) Section 1035 lets a policyowner exchange certain contracts without recognizing current gain, preserving the original cost basis in the new contract. It is a tax-free exchange, not a tax-free distribution.
Allowed 1035 Exchange Directions
| From | To | Allowed? |
|---|---|---|
| Life insurance | Life insurance | Yes |
| Life insurance | Annuity | Yes |
| Life insurance | Long-term care | Yes |
| Annuity | Annuity | Yes |
| Annuity | Long-term care | Yes |
| Annuity | Life insurance | No |
Exam trap: You can go life → annuity but not annuity → life. The IRS will not let untaxed annuity gain migrate into a tax-free life death benefit. A 1035 exchange must be a direct insurer-to-insurer transfer; if the owner takes a check, it becomes a taxable surrender.
Surrender and Death of the Owner
- Full surrender: taxable gain = surrender value − basis, taxed as ordinary income (plus 10% penalty if under 59 1/2).
- Death of owner before annuitization: the contract value passes to the beneficiary; gain is taxable as ordinary income (no step-up in basis like other property). A spouse may continue the contract; a non-spouse must distribute under post-death rules.
- Annuities receive no step-up in basis at death — a frequently tested distinction from appreciated stock or real estate.
Which of the following is a valid tax-free transaction under IRC Section 1035?
Annuitization Taxation and Beneficiary Treatment
While surrenders and withdrawals from a non-qualified deferred annuity are taxed LIFO (interest/gain out first, fully taxable, then tax-free basis), annuitized payments are taxed under the exclusion ratio: each payment is part return of basis (tax-free) and part gain (taxable) until the entire cost basis is recovered, after which payments become fully taxable.
| Distribution type | Tax order |
|---|---|
| Lump-sum surrender / partial withdrawal | LIFO — gain taxed first |
| Annuitized periodic payments | Exclusion ratio — basis spread across payments |
| Death proceeds to beneficiary | Gain taxable as ordinary income (no step-up); basis tax-free |
Beneficiary rule: Unlike life insurance, annuity death proceeds do not receive a tax-free death benefit — the beneficiary pays ordinary income tax on the gain (the difference between value and cost basis). There is no step-up in basis at the owner's death.
Trap: A 1035 exchange lets an owner swap one non-qualified annuity for another (or life-to-annuity) without triggering tax on the gain, but you cannot 1035 an annuity into a life insurance policy. Annuity → annuity and life → annuity are valid; annuity → life is not.