Annuity Taxation
Understanding how annuities are taxed is essential for both the licensing exam and advising clients. The tax treatment varies based on when and how distributions are taken.
Tax-Deferred Growth
During the accumulation phase, annuity earnings grow tax-deferred.
How Tax Deferral Works
| Taxable Account | Annuity |
|---|---|
| Interest taxed annually | No tax until withdrawal |
| Dividends taxed annually | Earnings compound tax-free |
| Realized gains taxed | No current tax on gains |
Benefit of Tax Deferral
Over long periods, tax deferral allows more money to compound:
| Investment | After 20 Years (6% return) |
|---|---|
| Taxable account (25% tax) | ~$262,000 |
| Tax-deferred annuity | ~$321,000 |
Assumes $100,000 initial investment.
Taxation of Withdrawals (Non-Qualified Annuities)
For non-qualified annuities (purchased with after-tax dollars), the IRS applies the Last-In, First-Out (LIFO) rule.
LIFO Rule
| Concept | Description |
|---|---|
| LIFO | Earnings (last in) are considered withdrawn first |
| Effect | Withdrawals are taxable until all earnings are withdrawn |
| After earnings | Remaining withdrawals are tax-free return of principal |
Example: LIFO Taxation
| Account Detail | Amount |
|---|---|
| Premiums paid (cost basis) | $100,000 |
| Current account value | $150,000 |
| Earnings (gains) | $50,000 |
If owner withdraws $30,000:
- First $30,000 is from earnings = fully taxable
- Owner would need to withdraw $50,000+ before reaching tax-free principal
LIFO Exception
If the annuity was purchased before August 14, 1982, withdrawals may use FIFO (First-In, First-Out), where principal comes out first.
The Exclusion Ratio
When an annuity is annuitized, a portion of each payment is tax-free (return of principal) and a portion is taxable (earnings). The exclusion ratio determines this split.
Exclusion Ratio Formula
Exclusion Ratio = Investment in Contract ÷ Expected Return
| Component | Definition |
|---|---|
| Investment in contract | Total premiums paid (cost basis) |
| Expected return | Payment amount × Expected number of payments |
Example: Exclusion Ratio Calculation
| Factor | Amount |
|---|---|
| Premiums paid | $200,000 |
| Monthly payment | $1,500 |
| Life expectancy at annuitization | 20 years (240 months) |
| Expected return | $1,500 × 240 = $360,000 |
| Exclusion ratio | $200,000 ÷ $360,000 = 55.56% |
Applying the Exclusion Ratio
Each $1,500 payment:
- Tax-free portion: $1,500 × 55.56% = $833.40
- Taxable portion: $1,500 × 44.44% = $666.60
After Recovering Investment
Once the annuitant has recovered their full investment ($200,000 in this example):
- 100% of each payment becomes taxable
- No more exclusion ratio applies
Exam Tip: The exclusion ratio applies only to annuitized payments, not random withdrawals. Withdrawals use LIFO; annuity payments use the exclusion ratio.
10% Early Withdrawal Penalty
The IRS imposes a 10% penalty on taxable distributions before age 59½.
Penalty Calculation
| Distribution | Calculation |
|---|---|
| Taxable portion | Subject to 10% penalty |
| Non-taxable portion | Not subject to penalty |
Example: Early Withdrawal
Owner age 55 withdraws $20,000 from a non-qualified annuity:
- $20,000 is all earnings (under LIFO)
- Income tax: $20,000 × 25% bracket = $5,000
- 10% penalty: $20,000 × 10% = $2,000
- Total tax cost: $7,000
Exceptions to the 10% Penalty
| Exception | Description |
|---|---|
| Age 59½ or older | No penalty |
| Death | Beneficiary distributions not penalized |
| Disability | Total and permanent disability |
| Substantially equal periodic payments (72(t)) | Series of payments over life expectancy |
| Immediate annuity | Purchased with after-tax dollars, annuitized immediately |
Qualified vs. Non-Qualified Annuities
Annuities can be classified as qualified (inside retirement accounts) or non-qualified (purchased with after-tax dollars).
Key Differences
| Feature | Qualified Annuity | Non-Qualified Annuity |
|---|---|---|
| Funding | Pre-tax dollars (IRA, 401(k)) | After-tax dollars |
| Tax deduction | Contributions may be deductible | No deduction for contributions |
| Taxation at withdrawal | 100% taxable | Only earnings are taxable |
| Required Minimum Distributions | Yes (starting at age 73) | No RMDs during owner's life |
| 10% penalty before 59½ | Yes | Yes (on earnings) |
Qualified Annuity Example
In a qualified annuity (IRA), owner contributed $100,000 pre-tax:
- 100% of withdrawals are taxable
- No cost basis (contributions were tax-deferred)
Non-Qualified Annuity Example
In a non-qualified annuity, owner contributed $100,000 after-tax:
- Only earnings above $100,000 are taxable
- Cost basis ($100,000) is returned tax-free
Death Benefit Taxation
When the annuity owner or annuitant dies, the beneficiary must pay taxes on any earnings.
Tax Treatment for Beneficiaries
| Situation | Tax Treatment |
|---|---|
| Non-spouse beneficiary | Must take distributions; earnings taxed |
| Spouse beneficiary | Can continue contract or take distributions |
| Annuitized payments remaining | Taxed under exclusion ratio |
| Lump sum death benefit | Earnings taxed as ordinary income |
Inherited Annuity Distribution Rules
| Beneficiary Type | Distribution Options |
|---|---|
| Spouse | Continue as owner, annuitize, or take lump sum |
| Non-spouse | Must begin distributions within one year of death |
| Trust | Depends on trust type and beneficiaries |
Key Takeaways
- Annuity earnings grow tax-deferred during accumulation
- Non-qualified annuity withdrawals use LIFO—earnings taxed first
- Annuitized payments use the exclusion ratio to determine taxable portion
- 10% penalty applies to taxable distributions before age 59½
- Qualified annuities (IRA, 401(k)) are 100% taxable at withdrawal
- Non-qualified annuities tax only the earnings portion
- After recovering the investment, 100% of payments become taxable
- Beneficiaries pay taxes on inherited earnings as ordinary income
For withdrawals from a non-qualified annuity, the IRS applies which taxation rule?
The exclusion ratio for annuitized payments is calculated as:
A 50-year-old withdraws $10,000 of earnings from their non-qualified annuity. The tax consequence is:
The difference between qualified and non-qualified annuities regarding taxation is that:
17.1 Income Tax Treatment
Chapter 17: Taxation of Life Insurance