Basic Income Tax Treatment of Nonqualified Annuities

A nonqualified annuity is a contract with an insurance company that is funded using after-tax dollars. This means the money used to purchase the annuity has already been subject to income tax and is not part of a tax-advantaged retirement plan like a 401(k) or a traditional IRA. This structure contrasts with a qualified annuity, which is funded with pre-tax dollars.

For a nonqualified annuity, the initial investment—the principal—is not taxed again upon withdrawal. The tax advantage of a nonqualified annuity is its ability to grow on a tax-deferred basis. Any earnings are not taxed as they accumulate, allowing the investment to compound without the drag of annual taxation.

Tax Treatment During the Accumulation Phase

The time when funds within a nonqualified annuity are invested and growing is the accumulation phase. If the owner takes a withdrawal from the contract before starting scheduled income payments, the tax treatment is governed by a specific rule. The Internal Revenue Service (IRS) applies a “Last-In, First-Out” (LIFO) rule to these distributions.

This rule dictates that earnings are considered to be withdrawn first, before any of the original investment. Since the earnings have not yet been taxed, they are fully taxable as ordinary income. Only after all accumulated earnings have been distributed can the owner begin to withdraw their after-tax principal tax-free.

To illustrate, consider an individual who purchased a nonqualified annuity for $50,000. Over several years, it grows to a value of $70,000, meaning it has $20,000 in earnings. If this individual takes a $15,000 withdrawal, the entire amount is considered a distribution of earnings and is subject to ordinary income tax. The remaining $5,000 of earnings would be the first portion distributed in any subsequent withdrawal.

Withdrawals of taxable earnings from a nonqualified annuity before the owner reaches age 59½ are also subject to a 10% early withdrawal penalty from the IRS. This penalty applies only to the taxable portion of the withdrawal. The 10% penalty may be waived in several specific situations, including:

• The death of the annuity owner
• The owner becomes totally and permanently disabled
• Distributions are part of a series of substantially equal periodic payments
• Distributions for certain qualifying medical expenses

Tax Treatment of Annuity Payouts

When the owner of a nonqualified annuity converts their accumulated funds into a steady stream of income, they enter the payout or “annuitization” phase. This is a formal election to receive regular payments for a specified period or for life. The tax treatment of these scheduled payments is different from the LIFO method.

For annuitized payments, the tax liability is determined using an “Exclusion Ratio.” This calculation determines the portion of each payment that is a tax-free return of the original investment and the portion that is taxable earnings.

The exclusion ratio is calculated by dividing the “Investment in the Contract” by the “Expected Return.” The Investment in the Contract is the net cost of the annuity, which is the total premiums paid with after-tax dollars. The Expected Return is the total amount the owner anticipates receiving, calculated by multiplying the annual payment amount by a life expectancy factor from IRS actuarial tables.

For example, an individual who is 65 years old purchases an immediate annuity for $100,000 and will receive $800 per month for life. Based on IRS tables, their life expectancy might be 20 years, making the expected return $192,000 ($800 x 12 months x 20 years). The exclusion ratio would be $100,000 divided by $192,000, which equals 52.1%. This means that 52.1% of each payment, or $416.80, is a tax-free return of principal, while the remaining $383.20 is taxable as ordinary income.

Once the total amount of tax-free payments received equals the original investment in the contract, any further payments become fully taxable.

Taxation for Beneficiaries

When the owner of a nonqualified annuity passes away, the tax implications for the beneficiary depend on their relationship to the owner and the choices they make. The earnings that have grown tax-deferred within the annuity do not receive a step-up in basis upon death, meaning the beneficiary will be responsible for the income tax on those gains.

A spousal beneficiary has the unique option to treat the inherited annuity as their own, which is referred to as a “spousal continuation.” By making this election, the surviving spouse effectively steps into the shoes of the original owner, and the tax-deferral on the contract’s earnings continues. Taxes become due when the surviving spouse begins taking withdrawals.

Non-spousal beneficiaries have more limited options. One choice is to take a lump-sum distribution of the entire annuity value, in which case all accumulated earnings are taxed as ordinary income in the year received. Another option for non-spousal beneficiaries is the “five-year rule.” This IRS regulation allows the beneficiary to withdraw the full value of the annuity over a period of up to five years, which can spread the tax impact. Some annuity contracts may also permit a non-spousal beneficiary to take distributions over their own life expectancy.

Special Circumstances and Reporting

A Section 1035 exchange allows an annuity owner to exchange one nonqualified annuity contract for another without triggering an immediate taxable event. The funds must be transferred directly between insurance companies to qualify, which allows the owner to move to a different product while preserving the original cost basis and continuing the tax deferral.

If an annuity owner surrenders their entire contract for less than their total after-tax investment, a loss may be recognized. This loss can only be claimed if the entire contract is liquidated, but such a loss is generally not deductible on an individual’s federal tax return through 2025.

All distributions from a nonqualified annuity are reported to the owner and the IRS on Form 1099-R. The insurance company that makes the payment is responsible for issuing this form. Key information on the form includes the gross distribution amount in Box 1 and the taxable amount in Box 2a. For a 1035 exchange, the form will show a distribution code of ‘6’ in Box 7 to indicate a tax-free transfer.