Non-Qualified Annuity Tax Rules

Written by Hersh Stern Updated Thursday, February 26, 2015

taxation of annuities

Annuities have become increasingly popular. Tax deferred growth is arguably the most appealing feature of a non-qualified annuity. This permits earnings on premiums to avoid income taxation until distribution. Long-term savings advantages and the ability to insure an income stream for life add to annuities' increasing appeal. As a consequence of their rising popularity, the past few years have brought a significant increase in the number of available annuity products.

In this article we review some of the most common tax concerns that arise around non-qualified annuities. Armed with this information, current and future annuity owners can proactively navigate around them. Before we start, though, its important to advise that the information on this page should not be taken as tax advice. You should consult with a competent tax professional before buying an annuity or before making changes to any existing annuity which may potentially trigger a taxable event.

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Types of Annuities

Annuities are classified in a number of different ways. For federal tax purposes, annuities are classified as either qualified or non-qualified. A qualified annuity is purchased as part of, or in conjunction with, an employer provided retirement plan or an individual retirement arrangement (such as an Individual Retirement Annuity or a Simplified Employee Pension Plan). If certain requirements are satisfied, contributions made to qualified annuities may be wholly or partially deductible from the taxable income of the individual or employer making the contributions.

A non-qualified annuity is not part of an employer provided retirement program and may be purchased by any individual or entity. Contributions to non-qualified annuities are made with after-tax dollars and are not deductible from gross income for income tax purposes. For the purposes of this article, we will limit further discussion to non-qualified annuities.

Annuities are also classified by type of investment and type of payout. Under a fixed annuity, the owner has both the security of a set rate of return and no investment decisions related to the annuity funds. The title "fixed annuity" does not mean that the earnings rate credited will never change; rather, it means that the earnings rate is set periodically by the issuer and then "fixed" until the rate is changed again.

Parties To an Annuity Contract

The three parties to an annuity contract are the owner, the annuitant, and the beneficiary. In many instances, the owner and the annuitant will be the same.

The owner is usually the purchaser of the annuity and has all the rights under the contract, subject to the rights of any irrevocable beneficiary. The owner is subject to income tax on all payments made from the annuity, regardless of who is named as payee or annuitant if different than the owner). When applicable, the penalty on any premature distributions is based on the owner's age. If the owner dies while the contract is in the accumulation phase (discussed later), there usually is a mandatory distribution of the death benefit (except when a spousal continuation rider takes effect).

The owner names the annuitant and the beneficiary of the annuity contract. The annuitant must be a natural person and serves as the measuring life for purposes of determining the amount and duration of any annuity payments made under the contract. The beneficiary receives the death benefit or any remaining annuity payments upon the death of the owner.

Natural Owner of an Annuity

The owner of an annuity may be a natural or non-natural person. A natural person is a human being, for example. Some examples of non-natural persons are corporations, partnerships, and trusts.

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An annuity contract will be treated as owned by a natural person even if the owner is a trust or other entity as long as that entity holds the annuity as an agent for a natural person. However, this special exception will not apply in the case of an employer who is the nominal owner of an annuity contract under a non-qualified deferred compensation arrangement for its employees. Immediate annuities are also excepted from the non-natural owner rule.

Why is it important to know if the owner is a natural person? Generally, only annuity contracts owned by natural persons are treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed deferred until withdrawn. On the other hand, annuity contracts owned by non-natural persons are not treated as annuity contracts for federal income tax purposes and the earnings on such contracts are taxed annually as ordinary income received or accrued by the owner during the taxable year. As with many other income taxation rules, there are several exceptions to the non-natural owner rule.

Non-Natural Owner of an Annuity

As stated earlier, contracts owned by "non-natural" persons are subject to annual tax on the inside buildup in the contract. Notable exceptions are contracts held in a trust or other entity as an agent for a natural person, immediate annuities, annuities acquired by an estate upon the death of the owner. Annuities are also not taxable if owned by a charitable organization or a pension plan.

Aggregation Rules

Purchasing several individual annuity contracts from a single insurance company within the same calendar year is often referred to as aggregation. In this scenario, the IRS treats these purchases as a single transaction in order to prevent the owner of the policies from manipulating the basis in each contract. Aggregation can result in an unexpected tax liability for the annuity owner. This rule does not apply when contracts are purchased from different insurance companies or if one annuity is deferred and another is immediate.

All contracts issued by the same company to the same policyholder during any calendar year will be treated as one contract for purposes of computing taxable distributions.

The following are exceptions to the aggregation rules: deferred annuity contracts which are exchanged into immediate annuities; immediate annuities; distributions required on account of the death of the owner; contracts issued prior to 10/21/88. Note, if a pre-10/21/88 contract is subsequently exchanged or transferred, the new contract becomes subject to the aggregation rules.

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Premature Distribution Penalty

Penalty:

10% of taxable amount.

Exceptions:

1. The owner is over age 59½ 2. The owner is disabled after contract purchase 3. The owner, not the non-owner annuitant, dies 4. Pre-TEFRA (prior to 8/14/82 contributions) non-qualified money 5. Immediate non-qualified annuity

Substantially equal payments

1. Must continue for 5 years or until owner reaches 59½, whichever is later 2. Must be computed based on life expectancy 3. Annuitization (for the owner's life or life expectancy

Note: An exchange from a deferred to an immediate annuity does not qualify as an immediate annuity for the purposes of avoiding tax penalty.

Tax Consequences of Ownership Changes

Types:

  • Addition/deletion of joint owner
  • Transfer to another individual or entity
  • Assignment

Taxation:

  • Earnings are subject to income tax at time of transfer
  • 10% penalty may apply
  • Gift taxes may apply

Exceptions:

  • Transfers between spouses
  • Transfers incident to divorce
  • Transfers between an individual and his/her grantor trust

Mandatory Distribution upon Death of Owner

If Owner dies Prior to Annuitization:

Surviving owner (or beneficiary) must elect one of the following:

  • immediate lump sum
  • complete withdrawal(s) within 5 years of death
  • annuitization (over the life of the new owner) to start within one year of death. If spouse is sole surviving owner (or beneficiary), spouse can also elect to continue contract. If owner is a grantor trust, death of grantor triggers mandatory distribution

Mandatory distribution applies to all contracts issued after 1/18/85

If Owner Dies After Annuitization:

Payments continue to beneficiary, based on annuitant's life and type of payment plan chosen

What are the phases of the annuity contract?

There are two distinct phases of the annuity contract: the accumulation phase and the annuitization phase. During the accumulation phase, the owner generally is not taxed on the earnings credited to the cash value of the annuity contract unless a distribution is received. The accumulation phase continues until the annuity contract is terminated or the annuitization phase begins. The annuitization phase starts when the contract value is applied to an annuity payout option. This phase continues until the last payment is made according to the annuity payout period chosen by the owner (or in some cases, the beneficiary).

How are the distributions taxed during the accumulation phase?

When an annuity contract is fully surrendered during the accumulation phase, the owner must pay income tax on the earnings in the contract. The owner is not taxed on amounts that represent a return of contributions (such as premiums or investment in the contract). Partial withdrawals from an annuity in the accumulation phase are taxed on a last in, first out (LIFO) basis. In order words, withdrawals from an annuity are made earnings first, and the owner is taxed on the payments until all of the earnings have been distributed. There is an exception to the earnings first rule for contributions made to annuity contracts prior to 8/14/82. These contributions are distributed on a first in, first out (FIFO) basis and the owner is not taxed until such contributions are fully recovered.

There is an aggregation rule which requires that all annuity contracts issued by the same company, to the same owner, in the same calendar year must be treated as one annuity contract for purposes of determining the taxable portion of any distributions.

How are distributions taxed during the annuitization phase?

Early Annuitization:

Annuities are designed to function as retirement investment vehicles, placing withdrawals after the attained age of 59 1/2. Should the annuity owner begin withdrawals following this age and assuming that they have satisfied any relevant surrender schedule, they will not be assessed fees outside of their tax liabilities. However, should the annuity owner opt to receive withdrawals prior to reaching the age of 59 ½, they may be subject to a 10% IRS penalty on any gains posted to-date. One exception to this rule is if the annuity owner has established an agreement with the IRS, referred to as substantially equal periodic payments (SEPP). Under this agreement, equal withdrawal payments can begin prior to the annuity owner’s age of 59 ½ without penalty as long as they continue to the agreed upon future date, which at a minimum is the later of age 59 ½ or a 5 year period.

During annuitization, a portion of each annuity payment represents a return of non-taxable investment in the contract and the balance of each payment is considered taxable income. The taxable and non-taxable portions of the payments are determined by an exclusion ratio. The exclusion ratio for a fixed annuity is the ratio the investment in the contract bears to the expected return under the contract. The exclusion ratio for a variable annuity is determined by dividing the investment in the contract by the total number of expected payments. Once the total amount of the investment in the contract is recovered using the exclusion ratio, the annuity payments are fully taxable. If the owner dies before the total investment in the contract is recovered, and annuity payments cease as a result of his death, the un-recovered amount is allowed as a deduction to the owner in his last taxable year.

When does the 10% penalty tax apply?

The 10% penalty tax generally applies to the taxable amount of distributions from annuities made before the owner attains age 59½. However, there are exceptions for distributions: (1) made as a result of the owner's death or disability; (2) made in substantially equal periodic payments over the life or life expectancy of the owner, or joint lives or joint life expectancy of the owner and designated beneficiary; (3) made under an immediate annuity; or (4) attributable to investment in the annuity made prior to 8/14/82.

What are the tax consequences of a transfer of ownership?

If an individual transfers ownership of a non-qualified annuity issued after 4/22/87, without full and adequate consideration, the owner must pay income tax on the earnings in the contract at the time of the transfer (except for transfers to a spouse or transfers made to a former spouse incident to a divorce). If the contract was issued before that date, the earnings in the contract can continue to be deferred, with the old cost basis carried over to the new owner. Transfer of ownership includes the addition or deletion of a joint owner. Also, the transfer of ownership may result in gift tax consequences for the owner.

Listing Annuities as Collateral Assignments

If the annuity owner lists their contract as collateral, its value will be treated as if it has been surrendered, thereby triggering applicable taxable gains.

Individuals who assign their annuities as collateral for loans may be surprised by the treatment of assignments. Generally, any collaterally assigned, pledged, or received as a loan under an annuity issued after 8/13/82 is treated as if it was distributed from the annuity. The amount collaterally assigned is taxed according to the rules applicable to partial withdrawals and full surrenders and may also be subject to the 10% penalty tax. If the entire contract is assigned or pledged, then earnings subsequently credited to the contract are automatically deemed subject to the assignment or pledge and are treated as additional partial withdrawals.

What happens at the owners' death?

Distributions

If the owner dies after the annuitization phase has begun, the remaining payments, if any, must be paid out at least as rapidly as under the annuity payout option in effect at the time of the owner's death. If a beneficiary receives the remaining payments under the annuity payout option in effect at the owner's death, the taxable and nontaxable portions of such payments will continue to be determined by the original exclusion ratio.

Withdrawals

Pre-TEFRA Contracts (Prior to 8/14/82):

  • Principal out first - Not taxable
  • Earnings outlast - fully taxable, but no penalty tax

Post TEFRA Contracts (After 8/13/82)

  • Earnings out first - Fully taxable and may be subject to penalty tax
  • Principal out last - Not taxable

Notes:

If a pre-TEFRA contract is subsequently exchanged, it keeps pre-TEFRA tax treatment. Sub-accounts are combined to compute income in the contract.

If the owner dies during the accumulation phase, the entire death benefit must be distributed within five years of the date of the owner's death. However, there is an exception to the five-year rule, if the death benefit is paid as an annuity over the life, or a period not longer than the life expectancy, of the beneficiary and the payments start within one year of the owner's date of death. If an annuity contract has joint owners, the distribution at death rules are applied upon the first death.

Under a special exception to the distribution at death rules, if the beneficiary is the surviving spouse of the owner, the annuity contract may be continued with the surviving spouse as the owner. If the owner of the annuity is a non-natural owner, then the annuitant's death triggers the distribution at death rules. In addition, the distribution at death rules are also triggered by a change in the annuitant on an annuity contract owned by a non-natural person. Income Tax. Unlike death benefits paid from life insurance policies, the beneficiary may be taxed on distributions made from an annuity after the owner's death. Amounts paid under the five-year rule are taxed in the same manner as partial withdrawals or full surrenders, and amounts paid under an annuity option are taxed in the same manner as annuity payments. For variable annuity contracts issued on or after 10/29/79, and for all fixed annuity contracts, there is no "step-up" in basis for income tax purposes and the beneficiary pays income tax on the earnings. However, the beneficiary is entitled to deduct a portion of estate tax paid on the annuity for income tax purposes. For variable annuity contracts issued prior to 10/21/79, there is a "step-up" in basis for income tax purposes and no income tax is payable on the earnings.

Deducting Capital Losses

If the annuity owner receives a lump sum distribution at a value below their cost basis, they may be able to claim the loss on their federal tax return if they itemize. Surrender charges assessed to the annuity owner following a withdrawal or surrender will not qualify as a loss under this ruling.

Classification of the Annuity’s Owner as a Trust

When the owner of a nonqualified annuity is a non-natural person, such as a trust, it is taxed on an annual basis and is ineligible for tax deferral benefits. One exception does exist; should the trust act in an agent capacity.

Trusts Listed as an Annuity’s Beneficiary

Most annuities offer three primary distribution options to listed beneficiaries; lump sum payment, even payments over a five year period or income payments over the life of the named beneficiary(ies). Should the beneficiary of the annuity be the spouse of the original owner, an additional option may be presented; for the surviving spouse to step in as the new owner of the annuity. If a trust is listed as the annuity’s beneficiary, no-look through provisions are offered. Essentially what this means is that the trust is ineligible to receive lifetime income payments. One exception to this general rule does apply; should the trust act as an agent of the spouse’s named beneficiary.

Gifting an Annuity

When an annuity is gifted to another party, the transaction triggers a taxable event for the donor. Any relevant capital gains will be taxed at the current owner’s tax bracket. And, should the gift occur prior to the annuity owner’s age of 59 ½, the transaction will be subject to a 10% IRS early withdrawal penalty. Two exceptions may apply; should the transfer occur between spouses or former spouse (as in the event of a divorce settlement), or if the annuity was issued prior to April 23, 1987. Annuities issued prior to this date will be taxed following donation when the contract is surrendered rather than at the time of transfer.

Grandfathered Annuities

Some previously purchased contracts may be eligible to receive favorable tax treatment. Withdrawals from annuities purchased prior to August 14, 1982 are subject to the first in, first out treatment. A step up in basis will be provided to beneficiaries of annuities purchased before October 21, 1979 upon the original contract owner’s death. If these original contracts are exchanged, these grandfathered benefits will be forfeited.

Required Minimum Distributions

IRAs with annuity holdings are subject to the IRS rule known as required minimum distributions (RMDs), which triggers when an individual reaches the age of 70 ½. RMD withdrawals, however, are NOT required to be taken from a non-qualified annuity. Simply stated, the concept of RMDs does not apply with non-qualified annuities.

Estate Tax

For federal estate tax purposes, the total value of the contract is subject to estate tax. Except as noted above, annuities are income in respect of a decedent and there is no "step-up" in basis for the contract and the annuity is subject to income tax when distributed.

Comments (6)

  1. Ken:
    Feb 09, 2015 at 12:52 PM

    I bought a $100,000 non-qualified fixed annuity. I withdraw the interest I earn each month keeping the principal at $100,000. Every year I pay taxes on this interest. When the surrender fee period ended last year I withdrew $30,000 from the principal, leaving $70,000 in the annuity. Today I received a 1099-R from the insurance company showing a taxable amount for last year’s withdrawals that included the interest plus $30,000 of principal. What should I do?

  2. Hersh Stern:
    Feb 09, 2015 at 12:55 PM

    Hi Ken-

    From the facts you described, the return of principal after all interest was withdrawn should have been coded as a non-taxable event. You may know that withdrawals from non-qualified annuities are taxed under the “LIFO” or Last-In-First-Out rule. So each year’s interest was correctly accounted for as taxable. But once there’s no interest left in your contract and you make another withdrawal, that last amount should have been described as non-taxable.

    What to do next?

    I’d start by calling the company and letting them know that their computer mistakenly lumped together the taxable interest amount with the principal amount. They should agree to send you a corrected 1099, which may take a few weeks for you to receive.

    If you don’t get the response you want, attach a brief letter to the incorrect 1099 when you file your taxes. Explain to the IRS why the 1099 is wrong. That should put it to rest. I wouldn’t stress too much about this since these kinds of mistakes do happen and 99% of the time the IRS will accept a policyholder’s explanation.

    -Hersh

  3. Sunghee:
    Feb 11, 2015 at 03:09 PM

    I surrendered my non-qualified variable annuity after 7 years. I received a Form 1099-R distribution notice from the insurance company which shows I received an amount that was a lot less than my initial investment. Where can I deduct this loss? Thank you.
    Sunghee

  4. Hersh Stern:
    Feb 11, 2015 at 03:44 PM

    Hi Sunghee,

    There are several steps to recognizing a loss from a variable annuity. Before you do anything though I strongly advise you to consult a CPA or tax attorney because the law is a bit fuzzy about what I'm telling you here:

    1. You start by surrendering your annuity for its cash value. You cannot take a loss if you just exchange your annuity for another one under Section 1035.

    2. You then calculate your "cost basis." This is the amount you originally paid for the annuity plus any additional premiums paid over time minus any withdrawals you took. If you were charged a surrender fee when cancelling the annuity that penalty needs to be added back in because surrender fees do not figure in your calculations of your reportable loss.

    3. There are two ways you can report your loss on a tax return. First, know that this kind of loss is not an "investment" or capital loss. So you can't offset profits from mutual funds or stock sales with an annuity loss.
    First approach: An annuity loss could be considered an "ordinary" loss which you include with your itemized deductions under "Miscellaneous Deductions." This would be a deduction only to the extent that your total Itemized Deductions exceeded 2% of your Adjusted Gross Income (AGI).

    Second approach: Some CPAs are more aggressive and tell you to deduct the full loss not just up to 2% of your AGI. They say you can enter your loss under the "Other Gains/Losses" section of your tax return. The precedent for this interpretation is Revenue Ruling 61-201, 1961-2, CB46.

    Either way, be sure to get a written opinion from a CPA or tax specialist. This is not intended to be proper tax advice. Please don't rely on my opinion.

    -Hersh

  5. Wilson:
    Mar 09, 2015 at 03:14 PM

    I have had a non-qualified annuity for 15 years. I would like to close it out. My statement shows a value listed as 'tax basis' and another for 'taxable gain'. Is the taxable gain the value I will have to pay taxes on when I receive my 1099-R? I am not yet 59-1/2 years old. Will there be an IRS 10% penalty even though I have held the annuity until maturity and there are no longer surrender fees?

  6. Hersh Stern:
    Mar 09, 2015 at 03:17 PM

    Hi Wilson,

    I’m afraid you will be subject to the 10% federal tax penalty on the taxable gains amount. The fact that you waited until your contract surrender fees no longer apply permits you to remove all the money without being charged a fee by the insurance company. But that’s a separate matter from the IRS penalty which I believe you are subject to unless you qualify for one of the listed exemptions to the penalty tax.

    -Hersh

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