How Are Non-Qualified Variable Annuities Taxed?

A non-qualified variable annuity is a contract between an individual and an insurance company. It functions as an investment vehicle for long-term savings, often supplementing retirement planning. Individuals fund these annuities with after-tax dollars, meaning contributions do not provide an immediate tax deduction.

The “non-qualified” designation signifies that the annuity is not part of a tax-advantaged retirement plan, distinguishing it from qualified annuities typically funded with pre-tax dollars. Despite not offering an upfront tax break, earnings within a non-qualified variable annuity grow on a tax-deferred basis. This means taxes on investment gains are postponed until money is withdrawn.

Taxation During Accumulation and Withdrawal

Non-qualified variable annuities offer tax-deferred growth during their accumulation phase. This allows earnings to compound without annual taxation until funds are withdrawn. This tax deferral can accelerate the growth of the investment over time compared to a taxable account.

When withdrawals are made from a non-qualified annuity, the IRS applies the “Last-In, First-Out” (LIFO) rule. Under this rule, earnings are considered to be withdrawn first, and these earnings are taxed as ordinary income. Only after all accumulated earnings have been withdrawn and taxed do subsequent withdrawals represent a return of the original, after-tax contributions (principal), which are then received tax-free.

A 10% early withdrawal penalty may apply to the taxable portion of withdrawals made before the annuity owner reaches age 59½. This penalty is imposed under Section 72. The penalty is in addition to ordinary income tax on earnings.

Several exceptions exist to this 10% penalty. Distributions made due to the annuitant’s death or disability are generally exempt. Another exception applies if withdrawals are part of a series of substantially equal periodic payments (SEPPs) made for the annuitant’s life or life expectancy, or joint lives. These SEPPs must continue for at least five years or until the annuitant reaches age 59½, whichever period is longer.

Taxation of Annuitized Payments

When a non-qualified variable annuity is annuitized into a stream of regular payments, each payment typically consists of a tax-free return of principal and a taxable portion of earnings. This distinction is managed through the “exclusion ratio,” a calculation that determines the percentage of each payment considered a tax-free return of the original investment.

To calculate the exclusion ratio, the investment in the contract (the after-tax contributions) is divided by the total expected return from the annuity. The expected return is based on factors such as the annuitant’s life expectancy or a set payment period. For instance, if the investment in the contract is $100,000 and the expected return is $200,000, the exclusion ratio would be 50%. This means 50% of each payment would be tax-free, and the remaining 50% would be taxed as ordinary income.

The exclusion ratio ensures that the original after-tax principal is returned to the annuitant tax-free over the payment period. Once the total amount of tax-free principal has been recovered, any subsequent payments received from the annuity are fully taxable as ordinary income.

Taxation of Death Benefits

When a non-qualified variable annuity holder passes away, the death benefit paid to beneficiaries has tax implications. The portion of the death benefit representing accumulated earnings is taxable to the beneficiary as ordinary income. The original principal, or after-tax contributions, is returned to the beneficiary tax-free.

Beneficiaries have several options for receiving the death benefit, and the chosen method affects the timing of tax liability. A lump-sum distribution means the entire taxable earnings portion is immediately subject to income tax in the year of receipt, potentially increasing the beneficiary’s tax bracket. Alternatively, beneficiaries might opt for annuitized payments or a “stretch” option, where payments are spread over their life expectancy. This allows the tax burden on the earnings to be distributed over a longer period, potentially reducing the immediate tax impact.

A surviving spouse often has additional flexibility, including the option to continue the contract as the new owner, preserving its tax-deferred status. Regardless of the distribution method, beneficiaries are responsible for paying taxes on earnings. The 10% early withdrawal penalty typically does not apply to death benefit distributions.

Tax Implications of Exchanges

Section 1035 allows for the tax-free exchange of one non-qualified annuity contract for another. This provision enables an annuity owner to transfer funds from an existing annuity to a new one without incurring immediate tax liability on the accumulated gains. This maintains the tax-deferred status of earnings, with taxes due only upon withdrawal from the new contract.

For an exchange to qualify, requirements must be met. The exchange must be a direct transfer between insurance companies, and contracts must be “like-kind.” For example, an annuity can be exchanged for another annuity. Cashing out an annuity and then purchasing a new one would not qualify as a 1035 exchange and would trigger immediate taxation of any gains.

Individuals might consider a 1035 exchange for reasons such as lower fees, different investment options, or more favorable features. While a 1035 exchange defers income tax on gains, it does not prevent potential surrender charges from the original annuity contract. The primary benefit is the ability to move accumulated value to a more suitable product without interrupting tax deferral.