Introduction to Annuity Taxation
One feature many annuity salespersons extol is the tax-deferred nature of an annuity. While it is true that annuities offer some distinct tax advantages, it is also true that they contain tax pitfalls for the unwary. The tax code regarding annuities is very complicated and, in many instances, not entirely clear. Many factors affect the ultimate outcome of an investment in annuities: ownership, beneficiary designations, distribution requirements, etc. It is easy for an advisor to make mistakes that could have serious consequences for both the client and advisor. Therefore it is very important that financial advisors be aware of the tax regulations — if for no other reason than to be aware of the limitations of their own understanding — and refer clients to expert tax advice when conditions warrant a referral.
This chapter will focus first on the tax treatment of non-qualified annuities — annuities purchased with after-tax dollars. Qualified annuities (purchased in qualified retirement plans and IRAs) are subject to an entirely different set of tax rules and are explored at the end of this chapter.
It is critical to make this distinction between qualified and non-qualified annuities. Non-qualified annuities represent the investment of after-tax dollars, which grows in a tax-deferred setting. Monies eventually received from a non-qualified annuity will be treated as either tax-free return of principal or taxable growth. Regardless of the source of that growth (interest in the case of fixed annuities, stock market gains in the case of variable contracts), the growth portion of the contract will always be taxed as ordinary income — never as capital gains.
As we learned in Chapter 1, there are two distinct periods in an annuity contract: the accumulation phase and the annuity phase. In the accumulation phase, the contractholder retains control over the contract’s cash value and may surrender the contract, make a partial withdrawal, exchange the contract for another annuity, or (in the case of variable annuities) redirect investments among subaccounts. Once the contract enters the annuity phase, however, the contractholder loses control — the contract simply distributes annuity payments using the payout method selected.
The tax code recognizes these two periods and applies different tax treatments to each. The tax code refers to annuity payments as “amounts received as an annuity”, while monies taken out during the accumulation phase are referred to as “amounts not received as an annuity.”
Income Tax Treatment During the Owner’s Lifetime
Regardless of who receives the funds, the contractholder will be taxed if the monies are disbursed from the contract while the contractholder is alive. In most cases, the contractholder will be the person receiving the funds — either through lifetime withdrawals or annuity payments. But in situations where the monies are paid to a third party, the contractholder will be taxed nonetheless. For example, a father buys an immediate annuity and directs the annuity payments to be paid to his daughter — the IRS will tax the father for the payments received by the daughter.
Amounts Received as an Annuity — The Exclusion Ratio
Under the tax code, an annuity is a series of payments that include the liquidation of the principal sum. The basic premise is that each periodic annuity payment is part interest and part return of principal. The interest or earnings portion of each payment is taxable as “ordinary income”, while the portion representing the return of principal is tax-free (excluded from tax).
To determine which portion of each annuity payment is tax-free, the IRS has established an exclusion ratio. This ratio is calculated differently depending on whether the annuity is a fixed or variable contract.
For fixed annuities, the exclusion ratio compares the total investment in the contract with the expected return. The total investment equals premiums paid by the contractholder to the annuity company, less any withdrawals or dividends received. The total investment is adjusted if the payout method includes any refund features (such as “lifetime with 10-year period certain” or “joint life with one-half survivor”). The expected return is based on the annuitant’s remaining life expectancy, using IRS life expectancy tables.
Exclusion ratio: $158,400 ÷ $264,000 = 60%
Each year Harry receives $15,000 in annuity payments:
• 60% is tax-free = $9,000 (return of principal)
• 40% is taxable = $6,000 (ordinary income)
At the end of 17.6 years, Harry will have received back his entire investment (17.6 × $9,000 = $158,400).
For variable annuities, the expected return cannot be accurately measured since it is based on the varying future value of a fixed number of annuity units. Instead, taxpayers calculate an annual exclusion amount by dividing the total investment in the contract by the life expectancy found in the IRS tables — spreading the return of principal evenly over the expected remaining life of the annuitant.
Annual exclusion amount: $158,400 ÷ 17.6 years = $9,000 per year tax-free
Any annual variable annuity payments Harry receives in excess of $9,000 will be taxable. In some years, investment results may not generate enough to pay out even the exclusion amount — in which case the entire payment will be received tax-free. Note that this $9,000 matches the fixed annuity calculation above — no coincidence, as both are based on the same investment and life expectancy.
While calculated differently, the exclusion ratio on a variable annuity performs the same function as it does for fixed annuities — it is a way to account for the tax-free return of principal in a series of periodic payments.
Calculating the proper amount of annuity payments to include on a tax return can be complicated. Financial advisors should be aware of the basic premise of an exclusion ratio and have a rough idea of how it is calculated — but many cases will require referral to a tax expert.
Amounts Not Received as an Annuity
Annuity payments are not the only way a contractholder may obtain funds from the contract. During the accumulation phase, the contractholder may surrender the entire contract, take a partial withdrawal, or exchange the contract for another. Each of these has a tax consequence.
Contracts issued before August 14, 1982 (FIFO): The IRS assumes that the first monies withdrawn represent the first monies in the contract — the premiums the contractholder paid. Withdrawals represent return of principal first; only after all tax-free principal is withdrawn does the contractholder begin receiving taxable income.
Contracts issued after August 13, 1982 (LIFO): The IRS applies a last-in, first-out method. The last monies added to the contract’s value (earnings) are the first to be withdrawn. Withdrawals are fully taxable earnings until all earnings are distributed; only the last dollars taken out represent tax-free return of principal.
Under FIFO (1980 contract): The $40,000 withdrawal is tax-free return of principal. The owner’s cost basis drops to $20,000. A 2005 withdrawal of $30,000 represents the last $20,000 of principal (tax-free) and $10,000 of taxable earnings. All future withdrawals will be fully taxable.
Under LIFO (if purchased in 1984): Both the 2004 and 2005 withdrawals would be fully taxable earnings. Only the last $60,000 taken from the account would be considered tax-free return of principal.
The FIFO/LIFO rules also apply to other distributions during the accumulation phase: dividend payments, loans, and pledging the contract as collateral for a loan. Simply pledging the contract as collateral might trigger adverse tax consequences.
- Contractholders can exchange an existing annuity for another annuity (tax-free)
- Life insurance policyholders can exchange their policy for another policy or an annuity (tax-free)
- An exchange from an annuity to a life insurance policy is not permitted under Section 1035
Common reasons for 1035 exchanges: switching from fixed to variable (or vice versa); upgrading to a higher-quality company; consolidating multiple contracts; obtaining less-restrictive terms or more favorable payout factors.
In a 1035 exchange, the contractholder simply carries the existing cost basis to the new annuity — future tax treatment will be based on that original investment. The LIFO/FIFO nature of the existing contract is also retained in the new contract.
Section 1035 also allows additional investment in conjunction with the exchange (the new cost basis includes both the original and added amounts). Partial 1035 exchanges are permitted, provided the taxpayer does not surrender the new, smaller contract within two years of the exchange. Cash received from a partial exchange (“boot”) is usually taxable.
Penalty for Premature Distributions
When Congress granted the benefit of tax deferral to annuities, it intended the contracts to be used as a retirement vehicle. To discourage the use of deferred annuities as a short-term investment for young people, Congress imposed a 10% penalty on premature distributions — similar to the penalty imposed on early withdrawals from qualified retirement plans.
Generally, the 10% penalty applies if withdrawals are taken from a non-qualified annuity prior to age 59½. Withdrawals may be taken without penalty if:
- The owner dies
- The owner becomes disabled
- A series of substantially equal payments are scheduled for the owner’s lifetime (or joint life expectancy of the owner and beneficiary)
- The contract was issued before August 14, 1982
Note: The 10% penalty applies only to the taxable portion of a premature distribution — it does not apply to the tax-free return of principal. (This differs from qualified retirement plans, where the penalty applies to the entire withdrawal, not just the taxable portion.)
Eligibility for Tax Deferral
Tax-deferred growth is one of the key selling points of an annuity — but this feature is not available to all contractholders. Only “natural persons” (human beings) enjoy a tax deferral. If a corporation, partnership, trust, estate or other organization owns the annuity, it will not receive the same favorable tax treatment. For these organizations, the growth in the account is taxable each year as earned, as ordinary income.
There are exceptions to this general rule:
- Estates that receive an annuity upon death
- Annuities held in a qualified retirement plan
- Annuities purchased to replace payments from a terminated qualified retirement plan
- Single premium immediate lifetime annuities that pay out at least annually
- Trusts or other entities that act simply as an agent for a natural person
The last exception is an important one for clients who set up trusts. An annuity held in a trust may enjoy tax-deferred status if the trust simply holds the annuity as an agent for an individual. In many revocable living (inter vivos) trusts, the trust is simply a surrogate for the trust grantor during his or her life — there should be no problem with the tax status of annuities held in such trusts.