How Are Nonqualified Annuities Taxed?

An annuity is a financial product, typically offered by insurance companies, designed to provide a steady stream of income, often for retirement. It functions as a contract where an individual makes payments to an insurer, either as a lump sum or a series of contributions, in exchange for regular disbursements that begin at a future date. These financial instruments allow for tax-deferred growth on earnings, meaning taxes are not due until withdrawals commence. A nonqualified annuity is distinct because it is purchased with after-tax dollars, meaning the contributions themselves were not tax-deductible. This characteristic significantly influences how the earnings and principal are taxed when funds are later accessed.

Understanding Nonqualified Annuities

A nonqualified annuity is a contract funded with money on which income taxes have already been paid. This distinguishes it from qualified annuities, which are typically part of employer-sponsored retirement plans or IRAs funded with pre-tax or tax-deductible contributions. The appeal lies in the tax-deferred growth of earnings within the annuity, where investment gains are not taxed annually but rather accrue without current taxation until distribution.

Annuities generally operate in two main phases. The first is the accumulation phase, during which you contribute funds and the money grows without current taxation on the earnings. The second is the payout or annuitization phase, when you begin receiving scheduled payments from the annuity. A fundamental concept in nonqualified annuity taxation is “cost basis,” which refers to the portion of your investment that consists of after-tax money you contributed. This cost basis is generally returned tax-free, as you have already paid taxes on these funds.

Taxation of Withdrawals

When you take withdrawals from a nonqualified annuity before it has been annuitized, meaning during the accumulation phase, the Internal Revenue Service (IRS) applies a specific tax rule known as “Last-In, First-Out” (LIFO). This rule dictates that any money withdrawn is considered to come from the earnings first, before any of your original, after-tax contributions. Consequently, these earnings are taxable as ordinary income up to the total amount of gains accrued in the contract. Only after all accumulated earnings have been withdrawn and taxed will subsequent withdrawals be considered a tax-free return of your principal, or cost basis.

In addition to ordinary income tax on the earnings, withdrawals made before age 59½ are generally subject to an extra 10% federal tax penalty. This penalty applies to the taxable portion of the withdrawal, which, under the LIFO rule, means the earnings. There are several common exceptions to this 10% penalty. These include withdrawals made due to the annuitant’s death or disability. Another exception is for substantially equal periodic payments (SEPPs) over your life expectancy, which must continue for at least five years or until you reach age 59½, whichever is later.

Taxation of Annuitized Payments

Once a nonqualified annuity is annuitized, meaning it is converted into a stream of regular, scheduled payments, the taxation method changes. Instead of the LIFO rule, the taxability of each payment is determined by an “exclusion ratio.” This ratio identifies the portion of each payment that is considered a tax-free return of your cost basis and the portion that is taxable earnings.

The exclusion ratio is calculated by dividing your investment in the contract (your cost basis) by the total expected return from the annuity over the payout period. For instance, if you invested $100,000 and expect to receive $150,000 in total payments, your exclusion ratio would be approximately 66.67%. This means roughly two-thirds of each payment would be tax-free, and the remaining one-third would be taxable as ordinary income. This method ensures that your original after-tax contributions are returned to you without being taxed again. Once the entire cost basis has been recovered tax-free through this exclusion ratio, all subsequent payments from the annuity become fully taxable as ordinary income. This approach applies consistently to both fixed and variable annuitized payments.

Other Tax Scenarios

The tax implications of nonqualified annuities extend beyond regular withdrawals and annuitized payments, particularly in scenarios such as death benefits or contract exchanges. When a beneficiary inherits a nonqualified annuity, the earnings portion of the death benefit is generally taxable as ordinary income to the beneficiary. The cost basis, representing the original after-tax contributions, is received tax-free.

Internal Revenue Code Section 1035 allows for tax-free exchanges of certain insurance products, including nonqualified annuities. This provision enables you to exchange one nonqualified annuity for another nonqualified annuity, a life insurance policy, or a long-term care insurance policy without triggering immediate taxation on any accumulated gains. However, if you choose to take a lump sum distribution from a nonqualified annuity instead of annuitizing it, this distribution is taxed under the LIFO rule, similar to withdrawals during the accumulation phase, where earnings are taxed first, followed by the tax-free return of principal.