10.3 Taxation of Annuities (LIFO, surrender, 1035 exchanges)
Key Takeaways
- Annuity earnings grow tax-deferred; distributions are taxed as ordinary income, never capital gains.
- Non-qualified withdrawals and surrenders use LIFO (earnings first, fully taxable) with a 10% penalty before age 59 1/2; pre-Aug-14-1982 contracts use FIFO.
- Annuitized payments use the exclusion ratio while withdrawals use LIFO - keep the two methods separate.
- Qualified annuities are 100% taxable and require RMDs starting at age 73; non-qualified annuities tax only earnings and have no lifetime RMD.
- Section 1035 permits life-to-annuity but not annuity-to-life exchanges, must be direct insurer-to-insurer, keeps the same owner, and carries over MEC status; inherited annuity gain is taxable with no basis step-up.
Tax-Deferred Accumulation
Like life insurance cash value, an annuity's earnings grow tax-deferred during the accumulation phase. No 1099 is issued for interest credited inside the contract; tax is owed only when money comes out. This deferral lets earnings compound on dollars that would otherwise be taxed each year, which is the annuity's core selling point as a retirement-savings vehicle.
The two big tax questions for any distribution are: (1) how much is taxable, and (2) is a penalty owed?
LIFO Taxation of Withdrawals
For a non-qualified annuity (bought with after-tax dollars), random withdrawals and partial surrenders are taxed under the Last-In, First-Out (LIFO) rule: the IRS treats earnings (the last money in) as coming out first, so withdrawals are fully taxable until all gain is exhausted; only then does the tax-free return of basis begin.
| Concept | Effect |
|---|---|
| LIFO ordering | Earnings out first = taxable; principal out last = tax-free |
| Tax character | Ordinary income (never capital gains) |
| 10% penalty | Applies to the taxable portion if owner is under age 59 1/2 |
| Historical FIFO | Contracts bought before August 14, 1982 use FIFO (basis first) |
Worked LIFO example: A non-qualified annuity has $80,000 basis and $110,000 value ($30,000 gain). A 52-year-old withdraws $20,000. Under LIFO all $20,000 is earnings: taxed as ordinary income, plus a $2,000 (10%) early-withdrawal penalty because the owner is under 59 1/2.
Withdrawals vs. Annuitization
Do not confuse the two distribution methods - the exam loves this contrast.
- Random withdrawal / surrender: Uses LIFO. Earnings come out first and are fully taxable.
- Annuitized payments: Use the exclusion ratio (from 10.1). Each payment is part tax-free basis and part taxable earnings until basis is recovered.
Full surrender: Surrendering the whole contract triggers tax on the entire gain (value minus basis) as ordinary income in that year, plus the 10% penalty if under 59 1/2. Surrender charges levied by the insurer are a contract cost, not a tax, and do not reduce the taxable gain.
Exceptions to the 10% Penalty
The 10% early-distribution penalty is waived in several situations even when the owner is under 59 1/2:
- Death of the owner (beneficiary distributions are not penalized)
- Total and permanent disability of the owner
- Substantially equal periodic payments under IRC Section 72(q)/72(t), taken over the owner's life expectancy
- An immediate annuity annuitized right after purchase
These exceptions waive only the penalty, not the income tax - the earnings portion is still ordinary income.
Qualified vs. Non-Qualified and RMDs
| Feature | Qualified annuity (IRA/401(k)) | Non-qualified annuity |
|---|---|---|
| Funding dollars | Pre-tax | After-tax |
| Cost basis | Usually zero | Equals premiums paid |
| Taxable at withdrawal | 100% taxable | Only the earnings |
| Required Minimum Distributions | Yes, generally beginning at age 73 | None during the owner's life |
| 10% early penalty | Yes (on taxable amount before 59 1/2) | Yes (on earnings before 59 1/2) |
RMD note: A qualified annuity must begin Required Minimum Distributions (RMDs) at the IRS required beginning age (73 under current law). Failing to take an RMD triggers an excise tax on the shortfall. Non-qualified annuities have no lifetime RMD because the IRS already taxed the contributions going in.
Section 1035 Exchanges and Death Benefits
IRC Section 1035 lets an owner swap one contract for a similar one without recognizing the gain - the deferral continues and the old cost basis carries over. Direction matters.
| From | To | Allowed under 1035? |
|---|---|---|
| Life insurance | Life, annuity, endowment, or qualified LTC | Yes |
| Annuity | Annuity or qualified LTC | Yes |
| Annuity | Life insurance | No (you cannot move into a tax-free death benefit) |
Key traps: a 1035 exchange must be a direct insurer-to-insurer transfer (a cash-in-hand swap is taxable), the owner and insured/annuitant must stay the same, and MEC status carries over to the new policy.
Death-benefit taxation: When the annuity owner dies before annuitizing, the beneficiary owes ordinary income tax on the gain (value minus basis); there is no step-up in basis as there is with most other inherited property. A spouse beneficiary may continue the contract and keep deferring; a non-spouse generally must begin distributions.
A 45-year-old takes a $15,000 partial withdrawal from a non-qualified deferred annuity that has $60,000 of basis and $50,000 of gain. What is the tax treatment?
Which exchange is permitted on a tax-free basis under IRC Section 1035?
LIFO Taxation of Nonqualified Withdrawals
Withdrawals from a nonqualified deferred annuity are taxed LIFO (last-in, first-out): the IRS treats the first dollars withdrawn as taxable earnings, not return of principal. A 10% penalty applies to the taxable portion if taken before age 59-1/2. This is the opposite of cost-basis-first treatment and a favorite distractor. Annuitized (periodic) payments instead use the exclusion ratio to spread basis recovery across payments.
1035 Exchanges and Surrender
A Section 1035 exchange lets an owner swap one annuity for another (or a life policy for an annuity) without triggering tax on the gain, carrying the old cost basis forward. The permitted directions are tested: life-to-life, life-to-annuity, and annuity-to-annuity are allowed, but annuity-to-life is NOT (you cannot 1035 'backward' into life insurance). Full surrender taxes all gain as ordinary income in the year received; surrender charges may also apply.
Under Section 1035, which of the following exchanges is NOT permitted on a tax-free basis?