6.3 Annuity Taxation

Tax-Deferred Growth

Non-qualified annuities are funded with after-tax dollars, so only the earnings are ever taxed. Growth compounds tax-deferred during accumulation, and there are no IRS contribution limits (unlike IRAs/401(k)s). When earnings are eventually withdrawn they are ordinary income — annuities never produce long-term capital-gains treatment, a frequent distractor.

A qualified annuity held inside a retirement plan is 100% taxable on distribution because nothing was taxed going in. Putting a tax-deferred annuity inside an already tax-deferred IRA adds cost with no extra tax benefit — a classic suitability red flag.

LIFO Withdrawals (Pre-Annuitization)

Random (non-annuitized) withdrawals follow LIFO — Last In, First Out: the most recent dollars (earnings) come out first and are fully taxable; basis comes out last, tax-free.

Worked example: Contract value $100,000; cost basis $60,000; earnings $40,000. The client withdraws $25,000. Under LIFO the entire $25,000 is earnings → fully ordinary-income taxable; $15,000 of earnings plus the $60,000 basis remain. If the client is under 59½, a 10% penalty also hits that $25,000.

Exclusion Ratio (During Annuitization)

Once annuitized, each check is split into a tax-free return of basis and a taxable earnings piece.

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

Worked example: Basis $120,000; expected lifetime return $300,000. Exclusion ratio = 120,000 / 300,000 = 40%. So 40% of every payment is tax-free return of principal and 60% is taxable. Once total basis has been recovered (the annuitant outlives the IRS life-expectancy table), 100% of further payments becomes taxable.

The 10% Early-Withdrawal Penalty

Taxable amounts taken before age 59½ owe a 10% IRS penalty on the earnings, plus ordinary income tax. The penalty hits the taxable (earnings) portion, not return of basis.

Trap: "First-time home purchase" and "qualified education" waive the penalty for IRAs, NOT for non-qualified annuities. Don't carry the IRA exceptions over.

Section 1035 Exchanges

IRC Section 1035 lets an owner swap like contracts tax-free, carrying the old cost basis forward.

Direction rule: you may go life → annuity, but never annuity → life (you cannot "trade up" into a death-benefit shelter). The transfer must be insurer-to-insurer with the same owner/annuitant; if cash touches the client's hands it becomes a taxable distribution. Surrender charges on the old contract can still apply, and recommending a 1035 only to generate a new commission is churning.

Surrender Charges vs. the 10% Penalty

A surrender charge (CDSC) is a contract fee that declines yearly (e.g., 7/6/5/4/3/2/1/0%). It is entirely separate from the IRS 10% tax penalty. A client under 59½ surrendering early can owe both — plus ordinary income tax on earnings. Always disclose this triple exposure before recommending an early surrender.

Why Ordinary Income, Never Capital Gains

A point the exam loves to test: no matter how the underlying subaccounts grew — even if an equity subaccount earned what looks like a long-term capital gain — annuity earnings are always taxed as ordinary income when distributed. The tax-deferral wrapper converts what would have been favorable capital-gains treatment in a taxable brokerage account into ordinary-income treatment. For a high-bracket client who would otherwise hold equities long-term in a taxable account, this can be a disadvantage, and it is a legitimate suitability counterargument the test rewards you for spotting.

Stepped-Up Basis Does Not Apply

Unlike directly held appreciated securities, an annuity's gain does not receive a step-up in cost basis at the owner's death. A beneficiary who inherits a non-qualified annuity inherits the original basis and owes ordinary income tax on the deferred earnings (this is "income in respect of a decedent"). This contrasts sharply with a taxable stock portfolio, where heirs receive a stepped-up basis. Expect a question framing annuities as poor wealth-transfer vehicles for this reason.

Inherited and Spousal Continuation

When an owner dies, a non-spouse beneficiary generally cannot continue tax deferral indefinitely; the gains must be distributed and taxed (commonly over five years or as a stretch where permitted). A surviving spouse, however, may elect spousal continuation, stepping into the owner's shoes and preserving tax deferral. RMDs at age 73 apply to qualified annuities and to inherited contracts under the applicable rules, but not to a living owner's own non-qualified annuity.

Section 1035 Mechanics Recap

To qualify for tax-free treatment, a 1035 exchange must be a direct insurer-to-insurer transfer with the same owner and the same annuitant/insured on both contracts. Carrying basis forward preserves the client's tax position, but a fresh surrender schedule on the new contract restarts the liquidity clock — the central reason reps must justify a 1035 on the client's needs, not the new commission. If the client takes constructive receipt of the cash, the protection collapses and the full LIFO/penalty rules above apply.