7.6 Taxation of Annuities
Individual Annuities
Qualified annuities are typically funded with pre-tax dollars. Because the contributions have not previously been taxed, all withdrawals and distributions are taxed as ordinary income. Since the premiums were tax deferred, they do not establish a cost basis in the contract.
In contrast, nonqualified annuities are funded with after-tax dollars. The premiums paid into the annuity, along with any additional contributions, create the cost basis of the contract. In simple terms, the cost basis represents the total amount invested in the deferred annuity. This amount serves as the starting point for determining any taxable gain or loss. During the accumulation phase, interest and investment earnings grow on a tax-deferred basis.
If the annuity is surrendered and paid out as a lump sum, any amount received above the cost basis is taxed as ordinary income.
If the annuity is annuitized, the original investment is returned through periodic payments over the payout period. The portion of each payment representing a return of principal is not taxable, while the remaining portion representing earnings is taxed as ordinary income. This tax treatment applies even if the earnings come from separate investment accounts within a variable annuity.
Exclusion Ratio
The taxation of annuity payments is generally determined using the exclusion ratio. The Internal Revenue Service (IRS) provides formulas and tables that help determine what portion of each annuity payment represents a tax-free return of the original investment (cost basis) and what portion represents taxable earnings. Once the entire cost basis has been recovered, all subsequent annuity payments become fully taxable as ordinary income.
A withdrawal refers to any amount taken from the annuity that is not part of the annuitization process. Withdrawals are taxed using the Last-In, First-Out (LIFO) method, meaning earnings are considered withdrawn first and are therefore taxed as ordinary income. In addition, withdrawals made before age 59½ are generally subject to a 10% early withdrawal penalty.
To determine the taxable portion of each annuity payment, the exclusion ratio is used. Under IRS rules, the portion of each payment considered a return of principal is calculated by comparing the investment in the contract (cost basis) to the expected return from the annuity. The expected return depends on the settlement option selected and represents the total amount the annuitant is expected to receive under the contract.
For variable annuity payments, the tax-free portion of each payment is calculated by dividing the investment in the contract by the total number of expected payments based on the selected settlement option. The taxable portion of the payment is then taxed at the annuitant's ordinary income tax rate.
Distributions at Death
If the annuitant dies during the accumulation phase of an annuity, the beneficiary who receives the death benefit must pay income tax on any gain in the contract. The taxable portion is taxed as ordinary income.
Estate Taxation
During the accumulation phase, if the contract owner dies, the value of the annuity is included in the owner's estate for estate valuation purposes.
If the annuitant dies during the payout (annuitization) phase, any remaining value in the annuity account is included in the annuitant's estate for valuation.
However, if the annuitant was receiving payments under a Pure Life (Straight Life) annuity, the payments end at the annuitant's death and the insurance company retains the remaining funds. In this case, no remaining value is included in the annuitant's estate.
Corporate-Owned Annuities
When an annuity is owned by a non-natural person, such as a corporation, it is not treated as a tax-deferred annuity for federal income tax purposes. Instead, any gains in the contract are taxed currently each year, rather than being allowed to accumulate tax deferred. As a result, corporate-owned annuities generally do not receive the typical tax advantages available to individual annuity owners.
Quiz
1. How are withdrawals from a qualified annuity generally taxed?
A. Only earnings are taxed
B. Only principal is taxed
C. All withdrawals are taxed as ordinary income
D. Withdrawals are tax free
Correct Answer: C
Rationale: Qualified annuities are funded with pre-tax dollars, meaning taxes were never paid on the contributions. As a result, all distributions—including both principal and earnings—are taxed as ordinary income when withdrawn.
2. What is the cost basis of a nonqualified annuity?
A. The death benefit value of the annuity
B. The total amount of premiums paid into the annuity
C. The total expected return from the annuity
D. The value of earnings accumulated in the annuity
Correct Answer: B
Rationale: Nonqualified annuities are funded with after-tax dollars, so the total premiums paid into the contract establish the cost basis. This amount represents the investor's principal and is not taxed when returned.
3. What does the exclusion ratio determine for annuity payments?
A. The tax rate applied to annuity payments
B. The portion of each payment that is tax free and the portion that is taxable
C. The amount of surrender charges owed
D. The minimum withdrawal amount
Correct Answer: B
Rationale: The exclusion ratio determines how much of each annuity payment represents a return of the original investment (tax free) and how much represents earnings (taxable as ordinary income).
4. How are withdrawals from an annuity during the accumulation phase generally taxed?
A. First-In, First-Out (FIFO)
B. Last-In, First-Out (LIFO)
C. Capital gains taxation
D. No taxation applies
Correct Answer: B
Rationale: Withdrawals taken from an annuity before annuitization follow the Last-In, First-Out (LIFO) rule. This means earnings are withdrawn first and taxed as ordinary income, before the return of principal.
5. What happens to the remaining value of a Pure Life (Straight Life) annuity when the annuitant dies?
A. It is paid to the beneficiary
B. It becomes part of the annuitant's estate
C. It is retained by the insurance company
D. It is refunded to the contract owner
Correct Answer: C
Rationale: Under a Pure Life (Straight Life) annuity, payments continue only for the life of the annuitant. When the annuitant dies, all payments stop and any remaining value is retained by the insurance company, meaning nothing passes to beneficiaries or the estate.