Taxation of Distributions

Understanding how annuity distributions are taxed is critical for both the licensing exam and for serving clients. The rules differ based on the type of distribution and whether the annuity is qualified or non-qualified.

LIFO Taxation of Withdrawals

For non-qualified annuities, withdrawals before annuitization follow LIFO (Last-In, First-Out) treatment:

LIFO Example

Non-Qualified Annuity:

• Account value: $150,000
• Cost basis: $100,000
• Gain: $50,000

Key Point: You cannot access your basis tax-free until ALL gains have been withdrawn first.

Exclusion Ratio for Annuitization

When a non-qualified annuity is annuitized (converted to periodic payments), each payment is partly taxable and partly tax-free return of basis.

Calculating the Exclusion Ratio

Exclusion Ratio = Investment in Contract / Expected Return

Where:

• Investment in Contract = Cost basis (premiums paid)
• Expected Return = Annual payment × Number of expected payments

Exclusion Ratio Example

Annuity Facts:

• Cost basis: $100,000
• Annual payment: $8,000
• Life expectancy: 20 years
• Expected return: $8,000 × 20 = $160,000

Exclusion Ratio = $100,000 / $160,000 = 62.5%

Each $8,000 Payment:

• Tax-free portion: $8,000 × 62.5% = $5,000 (return of basis)
• Taxable portion: $8,000 × 37.5% = $3,000 (earnings)

After Basis is Recovered

Once the annuitant has received their full basis (usually after life expectancy is reached):

• 100% of each payment becomes taxable
• The exclusion ratio no longer applies
• This protects those who live beyond life expectancy

Exam Tip: If the annuitant dies before recovering their full basis, the unrecovered basis is deductible on their final tax return.

10% Early Withdrawal Penalty

Distributions from annuities before age 59½ are subject to a 10% penalty tax on the taxable portion.

Exceptions to the 10% Penalty

Penalty Calculation

Example:

• Annuity owner age: 52
• Withdrawal: $20,000
• Taxable amount (gain): $15,000
• Ordinary income tax (25% bracket): $3,750
• 10% penalty: $1,500
• Total tax burden: $5,250

Qualified Annuity Distributions

For qualified annuities (held in IRAs, 401(k)s, etc.):

Required Minimum Distributions (RMDs)

Qualified annuities are subject to RMD rules:

2024 RMD Penalty Reduction:

• The penalty for missing an RMD was reduced from 50% to 25%
• Further reduced to 10% if corrected within 2 years

Taxation of Different Annuity Types

Partial Surrenders vs. Full Surrenders