3.5 Variable Annuity Taxation

Understanding the tax treatment of variable annuities is critical for the Series 6 exam and for making suitable recommendations. The rules differ significantly between qualified and non-qualified annuities, and withdrawals have important tax consequences.

Tax-Deferred Growth

The primary tax advantage of all annuities is tax-deferred growth:

• No current income tax on investment earnings
• Taxes paid only when money is withdrawn
• Allows compounding of pre-tax dollars

Key Benefit: In a taxable account, you'd pay taxes annually on dividends and capital gains. Inside an annuity, these grow tax-free until withdrawal.

Qualified vs. Non-Qualified Annuities

Qualified Annuities

• Funded with pre-tax money (traditional IRA, 401(k), etc.)
• 100% of withdrawals are taxable as ordinary income
• Subject to Required Minimum Distributions (RMDs) starting at age 73
• Same contribution limits as the underlying account

Non-Qualified Annuities

• Funded with after-tax money
• Only earnings portion is taxable
• No contribution limits
• No RMD requirements
• More common for Series 6 questions

LIFO Taxation: Earnings Come Out First

For non-qualified annuity withdrawals (not annuitized), the IRS uses Last-In, First-Out (LIFO) treatment:

LIFO Rule: Earnings are considered withdrawn FIRST, meaning withdrawals are 100% taxable until all gains are depleted.

LIFO Example

If the owner withdraws $20,000:

• Entire $20,000 is taxable as ordinary income
• It's considered earnings (LIFO)
• Cost basis remains $100,000

If they later withdraw another $40,000:

• $30,000 taxable (remaining earnings)
• $10,000 tax-free return of principal

Exam Tip: LIFO taxation for annuities is the OPPOSITE of life insurance withdrawals, which use FIFO.

Taxation During Annuitization (Exclusion Ratio)

Once a non-qualified annuity is annuitized, each payment is partially taxable and partially tax-free using the exclusion ratio:

Exclusion Ratio Formula

$$\text{Exclusion Ratio} = \frac{\text{Cost Basis}}{\text{Expected Return}}$$

• Cost Basis = Total premiums paid
• Expected Return = Annual payment × Expected years of payments

Exclusion Ratio Example

With a 50% exclusion ratio:

• Each $10,000 payment → $5,000 taxable, $5,000 tax-free
• This ratio remains fixed for life (even if annuitant outlives expectancy)

10% Early Withdrawal Penalty

Withdrawals before age 59½ are subject to a 10% penalty on the taxable portion, in addition to regular income tax:

Formula: Taxable amount + 10% penalty + surrender charges (if applicable)

Exceptions to 10% Penalty

The 10% penalty is waived for:

• Death (beneficiary withdrawals)
• Disability (unable to work)
• Substantially Equal Periodic Payments (SEPP/72(t))
• Immediate annuities (annuitized within 1 year of purchase)

Important: Surrender charges are imposed by the INSURANCE COMPANY. The 10% penalty is imposed by the IRS. Both may apply to the same withdrawal.

1035 Exchanges

Section 1035 of the Internal Revenue Code allows tax-free exchanges between certain insurance products:

Permitted 1035 Exchanges

Memory Tip: You can exchange "down" (life to annuity) or "across" (annuity to annuity), but not "up" (annuity to life).

Key 1035 Rules

1. Same owner - Must maintain same contract owner
2. Same annuitant/insured - Must be same person
3. No cash received - Entire value must transfer
4. Holding period tacks - Original holding period carries to new contract
5. Basis carries over - Cost basis transfers to new contract

1035 Exchange Considerations

Benefits:

• Avoid current taxation on gains
• Move to better-performing product
• Access newer features or lower fees

Risks:

• New surrender charge period begins
• May lose existing guarantees
• Could be unsuitable exchange

Death Benefit Taxation

When the annuitant dies during the accumulation phase:

Tax on Death Benefit:

• Earnings portion taxable as ordinary income to beneficiary
• Cost basis passes tax-free
• No step-up in basis (unlike stocks or real estate)

Key Point: Annuities do NOT receive a step-up in cost basis at death. This is a significant disadvantage compared to other assets.

Summary of Key Tax Rules