Income received from a nonqualified annuity under a structured annuitization option is taxed in accordance with the exclusion ratio. The exclusion ratio treats each annuity payment as part principal and part interest, thereby excluding a portion of each payment from tax and taxing a portion. The exclusion ratio is the “investment in the contract” (i.e., total premiums paid) divided by the “expected return” (i.e., total amounts to be received). If the expected return is not based on a life expectancy – as would be the case with a fixed term of years option, for example – it is calculated simply by adding the total amounts to be received. If the expected return is based on a life (or joint life) expectancy, certain IRS-prescribed tables and multipliers are used to determine the total expected return.
Taxation to the Beneficiary at the Annuitant’s Death (Post-Annuitization)
In cases where an annuitant owns a term certain or refund annuity and dies after payments begin but before receiving the full amount guaranteed, the balance is paid to a designated beneficiary. In these cases, the amounts paid to the beneficiary – whether as a single payment or in installments – are received tax free until the sum of all payments that were excluded from tax exceed total premiums invested. After that, any amounts the beneficiary receives are fully taxable.
Taxation to the Beneficiary at the Annuitant’s Death (Pre-Annuitization)
In cases where the owner is the same as the annuitant, what happens at the annuitant’s death is governed by the rules applicable at the owner’s death. In cases where the annuitant is different from the owner and the annuitant dies first, federal tax law does not require that taxes be paid unless the contract terminates, which many do. However, recent clarification on this issue by Congress and the IRS has given insurers confidence to design contracts that survive the death of a nonowner annuitant by naming a new annuitant. Often this is the owner or contingent annuitant.
One important exception to this occurs when the owner is a “non-natural” person, such as a trust. In these situations, the death of the annuitant results in exactly the same tax treatment as the death of an owner.
Taxation to the Beneficiary at the Owner’s Death
For contracts in deferral, federal tax law requires that any gain in the contract be recognized and consequent taxes paid whenever the owner dies. This is also true in the event of multiple owners when any owner dies. Therefore, most annuity contracts provide for payment of the death benefit to the beneficiary at the time of the owner’s death. This means that the beneficiary will be responsible for income taxes on the contract’s gain.
Taxation of Annuity Withdrawals and Distributions
There are a number of ways for contract owners to access the values in their annuities other than through annuitization. These options include systematic withdrawals, loans and full or partial surrenders, all of which can be utilized before an annuity’s maturity date. However, current tax laws are such that any of these distribution options may create a taxable event
For annuities purchased before August 14, 1982
, the general rule regarding cash withdrawals, amounts received as loans or amounts received on surrenders is that they are tax free until they equal the contract owner’s basis or investment in the contract. After that, they are fully taxable as income. These annuities are given “first-in, first-out” (FIFO) treatment.
Annuities purchased on or after August 14, 1982
, the general rule regarding these same kinds of distributions is that they will be treated first as fully taxable interest payments and only second as a recovery of non-taxable basis. These annuities are given “last-in, first-out” (LIFO) treatment.
Penalties for Early Distributions or Withdrawals
To promote the use of annuities as retirement plans and to discourage their use as short-term tax-sheltered investments, a 10% penalty is imposed on “premature” distributions, or those taken before the contract owner’s age 591/2. Therefore, an individual who, at age 54, withdraws a sum of $5,000 from his or her annuity will have to pay a current tax plus a $500 penalty as well, to the extent the withdrawal is attributed to interest earnings. No penalty is imposed for distributions taken:
Estate Taxation of Annuities
- After age 591/2;
- In the event of disability;
- In the event of death; or
- As part of a series of substantially equal payments taken over life expectancy.
If the contract owner dies during the deferral period (prior to annuitization), the entire account value of the annuity is included in his or her gross estate for purposes of determining the estate tax. If the contract owner dies after annuitization has begun and payments continue to a beneficiary (under period certain or survivor annuity), then the present value of those future payments is included in the contract owner’s gross estate. If the annuitization election is the life-only option, then there is no value for estate tax purposes, since payments cease at the contract owner’s death.
Last Updated: 9/23/2012 10:05:00 PM