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A portion of each annuity benefit payment is taxable, and a portion is not. The portion that is nontaxable is the anticipated return of the principal paid in — this is known as the cost base. The portion that is taxable is the interest earned on the principal — this is known as the tax base.
The accumulation phase is the period after an annuity has been purchased but before distributions begin.
The cost base represents premium dollars that have already been taxed and will not be taxed again when withdrawn from the contract. The interest accumulated in an annuity is the tax base, but taxes are deferred during the accumulation period.
When money is withdrawn from the annuity during the accumulation phase, the amounts are taxed on a last-in, first-out basis (LIFO). Therefore, all withdrawals will be taxable until the owner's cost basis is reached. After all of the interest is received and taxed, the principal will be received with no additional tax consequences.
Cash surrender of an annuity results in immediate taxation of the interest earned.
The IRS imposes a penalty for certain premature distributions under annuity contracts. In addition to any ordinary income tax that may be due, a 10% penalty is imposed on the annuity tax base for early withdrawals prior to age 59½.
Suppose a 58-year-old insured makes an early withdrawal from his annuity. If this withdrawal totals $6,000, and the entire amount is taxable, the insured can expect to receive a penalty equal to 10% of the withdrawal, or $600.
The exclusion ratio is used to determine the annuity amounts to be excluded from taxes. The annuitant is able to recover the cost basis nontaxable. The cost basis is the principal amount, or the amount that was paid into the annuity, which is excluded from taxes. The rest of each annuity payment is interest that has been earned and is taxable.
When an annuity is used to fund a traditional IRA, distributions are fully taxable if contributions were made with pretax dollars. If there are no distributions at the required age, or if the distributions are not large enough, the penalty is 25% of the shortfall from the required annual amount.
If the annuity contract holder dies before the annuitization date, the interest accumulated in the annuity becomes taxable. If the beneficiary of the annuity is a spouse, however, the tax can continue to be deferred.
Any unpaid annuity benefits following the death of an annuitant are paid to the beneficiary and are taxable.
If the annuitant died during the accumulation period, the insurer is obligated to return all or a portion of the annuity cash value (values accumulated in the annuity in accordance with contract terms), which will be included in the deceased annuitant's estate. If the annuity has been paid up, and the annuitant dies during the annuity period, the annuity benefits will be taxable and will be included in the deceased annuitant's estate.
Corporate-owned annuities have different tax implications than individual annuities:
| Item | Tax Treatment |
|---|---|
| Premiums | Not deductible (personal expense) |
| Death Benefit | Not income taxable (except for interest) |
| Cash Value Increases | Not taxable (as long as policy in force) |
| Cash Value Gains | Taxed at surrender |
| Dividends | Not taxable (return of unused premium; however, interest is taxable) |
| Accumulations | Interest taxable |
| Policy Loans | Not income taxable |
| Surrenders | Surrender value minus past premium equals amount taxable |
| Partial Surrenders | First In, First Out (FIFO)* |
Tax Considerations for Life Insurance and Annuities
Settlement Options — the death benefit is spread evenly over the income period (averaged); interest payments in excess of the death benefit portion are taxable.
Estate Tax — if the insured owns the policy, it will be included for estate tax purposes. If the policy is given away (possibly to a trust) and the insured dies within 3 years of the gift, the death benefit will be included in the estate.
*FIFO applies to life insurance only. The policyowner receives their investment in the contract first, before receiving any gains in the policy (or being taxed on those gains). Annuities instead follow a LIFO (last in, first out) format.