Annuity LIFO: How Withdrawals Are Taxed

An annuity is a contract with an insurance company that provides income, often during retirement. These financial products allow funds to grow on a tax-deferred basis, meaning you do not pay taxes on the earnings each year. When you begin to withdraw money, the tax implications arise. For non-qualified annuities, the Internal Revenue Service (IRS) mandates that withdrawals are taxed according to the “Last-In, First-Out” (LIFO) principle.

The LIFO Tax Principle for Annuities

The Last-In, First-Out (LIFO) principle dictates the order in which funds are withdrawn from an annuity for tax purposes. Any withdrawal is considered to come from accumulated earnings first. These earnings are taxed at the owner’s ordinary income tax rate, not the lower capital gains rate. Only after all earnings have been withdrawn are subsequent withdrawals considered a tax-free return of the original investment, also known as the cost basis.

This tax treatment specifically applies to non-qualified annuities, which are funded with after-tax dollars.

The tax treatment for qualified annuities differs. Qualified annuities are funded with pre-tax dollars, often within a retirement plan like a 401(k) or an IRA. Since neither the contributions nor the earnings have been previously taxed, virtually all withdrawals from a qualified annuity are subject to ordinary income tax.

Calculating the Taxable Withdrawal Amount

To understand the tax impact of a withdrawal, you must identify the two components of your non-qualified annuity’s value: the cost basis and the earnings. The cost basis is the total amount of premiums you have paid into the contract using after-tax money. The earnings represent the contract’s total current value minus your cost basis.

Consider an individual who has contributed $100,000 to a non-qualified annuity, which is their cost basis. Over several years, the annuity grows to $140,000, generating $40,000 in earnings. The owner decides to take a partial withdrawal of $50,000 from the contract.

Following the LIFO rule, the first $40,000 of the $50,000 withdrawal is fully taxable as ordinary income. The remaining $10,000 is treated as a tax-free return of a portion of their original cost basis. After this transaction, the annuity’s remaining value is $90,000, all of which is considered cost basis.

The Early Withdrawal Penalty

Beyond ordinary income tax, a withdrawal from a non-qualified annuity may be subject to an additional federal tax penalty. If the annuity owner is under age 59½, the taxable portion of a withdrawal is generally subject to a 10% penalty. This penalty is assessed by the IRS on top of the regular income tax owed and applies only to the earnings portion of the withdrawal.

Using the previous example, the $40,000 of earnings withdrawn would be subject to this 10% penalty if the owner is younger than 59½. This would result in an additional tax of $4,000. This penalty is separate from any surrender charges that the insurance company might impose for early withdrawals based on the contract’s terms.

The IRS allows for several exceptions to the 10% early withdrawal penalty. The penalty is waived if the withdrawal is made after the owner’s death or if the owner becomes disabled, as defined by the Internal Revenue Code. Another exception applies if the funds are taken as a series of substantially equal periodic payments over the owner’s life expectancy, a process known as annuitization.

Tax Reporting for Annuity Withdrawals

When you take a distribution from an annuity, the insurance company must report the transaction to you and the IRS using Form 1099-R, Distributions From Pensions, Annuities, etc. You will receive this form in January of the year following the withdrawal, and it contains the information needed to report the income on your tax return.

The form provides specific details about your distribution. Box 1 shows the total gross distribution you received. Box 2a reports the taxable amount of that distribution, which the company calculates based on your cost basis and the LIFO principle.

Box 7 of Form 1099-R contains a distribution code that tells the IRS the reason for the payment. For example, a code ‘1’ indicates an early distribution where no known exception to the 10% penalty applies. A code ‘7’ signifies a normal distribution for an owner who is over age 59½. Understanding these codes helps you correctly file your return and determine if any additional taxes or penalties are owed.