How Does Variable Annuity Taxation Work?

A variable annuity is an insurance contract that merges investment features with the potential for tax-deferred growth. The value of the annuity fluctuates based on the performance of underlying investments you select, which are similar to mutual funds. This structure introduces both market risk and the possibility of higher returns compared to fixed annuities.

The tax regulations for variable annuities are distinct. Unlike direct investments where gains may be taxed annually, earnings within a variable annuity are not taxed until money is withdrawn. Understanding how these rules apply during the annuity’s different phases is important, as the tax implications vary based on how it is funded and how money is accessed.

Tax Treatment During the Accumulation Phase

The tax rules for a variable annuity during its accumulation phase, the period when your money is invested and growing, hinge on whether the annuity is classified as qualified or non-qualified. A qualified annuity is funded with pre-tax dollars, meaning contributions were made before income taxes were paid. These are often part of retirement plans like a 401(k) or a traditional Individual Retirement Account (IRA), where you receive an upfront tax deduction on contributions.

In contrast, a non-qualified annuity is purchased with after-tax dollars. You do not receive a tax deduction for these contributions, so the initial investment, or principal, has already been taxed. This fact becomes important when distributions begin.

The primary tax advantage during the accumulation phase for both types is tax-deferred growth. As the underlying investments generate interest, dividends, or capital gains, you do not owe any taxes on those earnings in the year they occur. The value of your account can compound over time without being reduced by annual tax payments, allowing it to potentially grow more rapidly than a comparable taxable investment.

Taxation of Withdrawals

When you take a withdrawal from a variable annuity, the tax implications differ based on whether the annuity is non-qualified or qualified. For non-qualified annuities, the Internal Revenue Service (IRS) applies a Last-In, First-Out (LIFO) principle. This means that withdrawals are considered to come from the earnings portion of your account first, and these earnings are fully taxable as ordinary income.

Once all the earnings have been withdrawn, any subsequent withdrawals are treated as a tax-free return of your original principal. For example, if you invested $100,000 of after-tax money and it grew to $150,000, the first $50,000 you withdraw would be fully taxable as ordinary income.

Withdrawals from qualified annuities are treated more simply. Because these annuities are funded with pre-tax dollars, both the contributions and the earnings have not yet been taxed. Therefore, any amount you withdraw is generally fully taxable as ordinary income.

A significant consideration for withdrawals from either type of annuity is the 10% early withdrawal penalty. The IRS imposes this additional tax on the taxable portion of any withdrawal made before you reach age 59½. This penalty applies on top of your regular income tax and is a major factor for those considering accessing their funds early. There are some exceptions, such as in the event of the annuity owner’s death or disability.

Tax Rules for Annuitized Payments

When you choose to annuitize your contract, you convert your account balance into a series of regular, guaranteed payments. The tax treatment of these payments is distinct from lump-sum withdrawals and again depends on whether the annuity is non-qualified or qualified.

For non-qualified annuities, the taxation of each payment is determined by an “exclusion ratio.” This calculation separates each payment into two parts: a tax-free return of your principal and taxable income. The exclusion ratio is calculated by dividing your total investment in the contract by the expected return.

To illustrate, suppose you invested $100,000 in a non-qualified annuity and your expected return is $250,000. The exclusion ratio would be 40%. This means that 40% of each payment you receive is a tax-free return of your principal, and the remaining 60% is taxable as ordinary income.

The situation is much simpler for qualified annuities. Since the entire contract value consists of pre-tax contributions and untaxed growth, each annuitized payment you receive from a qualified annuity is fully taxable as ordinary income.

Tax Consequences for Beneficiaries

When an annuity owner dies, beneficiaries must choose a distribution option with significant tax implications. One common option is to take a lump-sum distribution, receiving the entire remaining value at once. For a non-qualified annuity, the beneficiary must pay ordinary income tax on the difference between the contract’s value and the owner’s investment. If the annuity is qualified, the entire amount is taxable as ordinary income, which can result in a large tax bill in a single year.

For most non-spousal beneficiaries, a “10-year rule” applies, requiring the entire balance to be withdrawn by the end of the 10th year following the owner’s death. If the owner died after their required start date for RMDs, the beneficiary must also take annual distributions in years one through nine.

A life expectancy payout, or “stretch” option, is only available to individuals classified as “Eligible Designated Beneficiaries.” This group includes:

• The surviving spouse
• Minor children of the account owner
• Disabled or chronically ill individuals
• Beneficiaries not more than 10 years younger than the deceased

For minor children, this option only lasts until they reach the age of majority, at which point the 10-year rule applies. A surviving spouse has the most flexibility, as they can also choose to treat the inherited annuity as their own. This spousal continuation allows the tax deferral to continue until the surviving spouse begins taking withdrawals.

Understanding 1035 Exchanges

A 1035 exchange is a provision within the U.S. Internal Revenue Code that allows for the tax-free transfer of funds from one annuity contract to another. The purpose is to permit annuity owners to move to a different product with better features or lower fees without immediately triggering a taxable event.

The core requirement is that the transfer must be “like-for-like,” meaning you can exchange an annuity for another annuity. The funds must be transferred directly from the old insurance company to the new one. If you were to receive a check to purchase the new contract, the transaction is considered a taxable distribution.

When executed properly, the original cost basis and tax-deferred status of the first annuity are carried over to the new contract.