8.2 Taxation of Annuities
Key Takeaways
- Annuity cash value grows tax-deferred; gains are taxed as ordinary income, never capital gains.
- Pre-annuitization withdrawals from a nonqualified annuity are taxed LIFO (gain first), with a 10% penalty before age 59 1/2.
- Once annuitized, the exclusion ratio determines the tax-free return of basis in each payment.
- After total basis has been recovered, all subsequent annuity payments are fully taxable.
- Annuity death proceeds do not receive a step-up in basis; the gain is taxable income to the beneficiary.
Taxation of Annuities
Annuities are the mirror image of life insurance: where life insurance is designed for premature death, annuities protect against living too long. Their tax treatment reflects this. Gains accumulate tax-deferred but are always taxed as ordinary income when distributed — there is no capital-gains rate and no step-up in basis at death.
Accumulation Phase
During accumulation, interest, dividends, and investment gains inside a nonqualified annuity are not currently taxed. The owner's cost basis equals the after-tax premiums paid in; everything above basis is gain.
Pre-Annuitization Withdrawals — LIFO
For contracts issued after August 13, 1982, partial withdrawals before annuitization are taxed LIFO (last-in, first-out): the gain comes out first and is fully taxable, and only after all gain is exhausted do you recover basis tax-free.
- A 10% federal penalty applies to the taxable portion if taken before age 59 1/2 (exceptions: death, disability, substantially equal periodic payments).
Example: A nonqualified annuity has $90,000 of value and $60,000 of basis (so $30,000 of gain). A $20,000 withdrawal at age 50 is entirely gain — $20,000 is ordinary income plus a $2,000 (10%) penalty.
Annuitization Phase — The Exclusion Ratio
Once the contract is annuitized into a stream of payments, each payment is split into a tax-free return of basis and a taxable earnings portion. The split is set by the exclusion ratio:
Exclusion Ratio = Investment in the Contract (basis) / Expected Return
The expected return is the monthly payment multiplied by the number of payments expected under the payout option (using the annuitant's life-expectancy factor for life options).
Worked example:
- Investment in the contract (basis): $100,000
- Annuitant's life expectancy: 20 years
- Monthly income: $625 (annual = $7,500)
- Expected return = $7,500 × 20 = $150,000
- Exclusion ratio = $100,000 / $150,000 = 66.67%
- Each $625 payment: $416.69 tax-free (66.67%) + $208.31 taxable (33.33%)
Key rule: Once the annuitant has recovered the entire $100,000 of basis (after living past life expectancy), ALL subsequent payments become 100% taxable. Conversely, if the annuitant dies early before recovering basis, the unrecovered basis is deductible on the final return.
An annuitant has $80,000 of basis and an expected return of $200,000. Each monthly payment is $1,000. How much of each payment is excluded from taxable income?
A 52-year-old takes a $15,000 withdrawal from a nonqualified deferred annuity that has $70,000 of value and $40,000 of basis. What is the federal income-tax result?
Qualified vs. Nonqualified Annuities
The tax rules above describe a nonqualified annuity, bought with after-tax dollars. A qualified annuity funds an IRA or employer plan with pre-tax dollars; it has no separate basis, so the entire payout is taxable as ordinary income, and it is subject to Required Minimum Distribution (RMD) rules. The exclusion ratio only matters where the owner has after-tax basis to recover.
| Feature | Nonqualified Annuity | Qualified Annuity |
|---|---|---|
| Funding | After-tax dollars | Pre-tax dollars |
| Basis to recover | Yes (premiums paid) | Generally none |
| Taxable portion of payout | Gain only | Entire payout |
| RMDs | None | Yes (age 73) |
Other Annuity Tax Points
| Issue | Rule |
|---|---|
| Character of gain | Always ordinary income (no capital gains) |
| Step-up at death | None — deferred gain is income to beneficiary (IRD) |
| Pre-59 1/2 penalty | 10% on taxable portion, with exceptions |
| 1035 exchange | Annuity → annuity is tax-free; annuity → life is taxable |
| Aggregation rule | Multiple deferred annuities from the same insurer issued in the same calendar year are aggregated to compute taxable gain on withdrawal |
| Corporate/nonnatural owner | Loses tax deferral unless held as an agent for a natural person |
Death of the Owner or Annuitant
Unlike life insurance, annuity death proceeds are not income-tax-free. The beneficiary pays ordinary income tax on the gain (the excess over basis) as income in respect of a decedent (IRD). There is no step-up in basis to erase the deferred gain. A surviving spouse may continue the contract as the new owner and keep deferring; nonspouse beneficiaries generally must distribute the contract under post-death payout rules (lump sum, five-year rule, or stretch over life expectancy where allowed).
During the accumulation phase, if the owner dies, the contract value passes to the beneficiary even though the annuitant may still be alive — owner and annuitant are distinct parties, and it is the owner's death that triggers the distribution-at-death requirements.
Exam trap: Candidates confuse the life-insurance death-benefit exclusion with annuities. Annuity death proceeds are taxable on the gain — there is no 101(a)-style exclusion and no basis step-up.