How Variable Annuities Are Taxed: An Overview

A variable annuity is a contract with an insurance company for long-term financial goals, blending investment and insurance features. An individual makes payments to the company, which invests the funds into a portfolio of subaccounts, similar to mutual funds. The annuity’s value fluctuates based on investment performance, and its defining characteristic is its tax treatment, which changes depending on how it is funded and when money is accessed.

The tax implications depend on the contract’s phase, whether it is in the accumulation (growth) or payout (distribution) period. Understanding these rules is important for assessing how a variable annuity fits into a financial strategy. The tax principles apply differently during the owner’s life and to beneficiaries after death.

Core Tax Principles of Variable Annuities

The tax treatment of a variable annuity is first determined by how it is funded. A non-qualified annuity is purchased with after-tax dollars, meaning the owner has paid income tax on the principal. This initial investment is the cost basis, which will not be taxed again when withdrawn.

Conversely, a qualified annuity is funded with pre-tax dollars, often within employer-sponsored retirement plans like a 401(k) or a traditional IRA. Contributions to these plans are often tax-deductible, so the entire amount inside the annuity—both principal and growth—has not yet been taxed. This distinction determines how all future withdrawals are treated by the IRS.

A primary feature of all variable annuities, whether qualified or non-qualified, is tax-deferred growth. While the funds are invested in the annuity’s subaccounts, any earnings, dividends, or capital gains generated are not subject to annual income tax. This allows the account’s value to compound over time without the drag of yearly taxes. The tax obligation is postponed until the owner begins to take money out of the contract.

Taxation of Withdrawals During Accumulation

When an owner withdraws funds from a non-qualified variable annuity before annuitization, the IRS applies the “Last-In, First-Out” (LIFO) rule. Under LIFO, all earnings in the contract are considered to be withdrawn first. These earnings are fully taxable as ordinary income at the owner’s current tax rate.

For example, if an individual contributes $100,000 of after-tax money to a non-qualified annuity and it grows to $150,000, the contract has $50,000 in earnings. If the owner withdraws $30,000, the entire amount is considered a withdrawal of earnings and is fully taxable. Only after all earnings have been withdrawn would subsequent withdrawals be treated as a tax-free return of the principal.

For qualified annuities, the tax treatment of withdrawals is more straightforward. Since the contract was funded with pre-tax dollars, any amount withdrawn during the accumulation phase is fully taxable as ordinary income. There is no distinction between principal and earnings.

Withdrawals of taxable earnings from an annuity before the owner reaches age 59½ are subject to a 10% federal penalty tax. This penalty applies to the taxable portion of the withdrawal. Certain exceptions can apply, such as death, disability, or taking a series of substantially equal periodic payments.

Funds can be moved from one annuity to another without an immediate tax event through a 1035 exchange. This process allows for the direct transfer of an existing annuity to a new one, deferring taxes on the gains. The cost basis from the old contract carries over, and the owner and annuitant must remain the same.

Taxation of Annuitized Payouts

When the owner of a non-qualified variable annuity chooses to annuitize, they convert the accumulated value into a series of regular payments. The taxation of these payments is determined by an “exclusion ratio.” This calculation separates each payment into a tax-free return of the owner’s after-tax principal and taxable income from earnings.

The exclusion ratio is calculated by dividing the total investment in the contract by the expected return, based on IRS actuarial tables. For example, if an individual invested $120,000 and their expected return is $200,000, the exclusion ratio is 60%. This means 60% of each payment is excluded from income tax, while the remaining 40% is taxable as ordinary income.

Once the total of the tax-free portions of payments equals the original investment, any further payments are fully taxable. If the annuitant dies before recovering their entire investment, the unrecovered portion may be taken as a deduction on their final income tax return. For variable annuities with fluctuating payments, the tax-free portion is determined by dividing the investment by the number of expected payments.

The tax treatment of annuitized payouts from a qualified annuity is simpler. Because the entire value consists of pre-tax money, every payment received is fully taxable as ordinary income. There is no exclusion ratio to calculate.

Tax Treatment for Beneficiaries

When an annuity owner dies, the tax implications for the beneficiary depend on the annuity type. For a non-qualified annuity, the beneficiary owes income tax only on the earnings portion of the death benefit; the cost basis is received tax-free. If the annuity was qualified, the entire death benefit is taxable to the beneficiary as ordinary income.

A lump-sum distribution makes all taxable gains immediately taxable in the year of receipt. This option provides immediate access to the funds but can result in a significant tax bill for that year.

Another option is the five-year rule, which allows a beneficiary to withdraw the proceeds at any point within five years of the owner’s death. This provides flexibility to spread the tax liability over several years, as taxes are due only when withdrawals are made. All funds must be distributed by the end of the fifth year.

The SECURE Act of 2019 changed the rules for many beneficiaries. Most non-spouse beneficiaries must now withdraw the entire balance of an inherited qualified annuity within 10 years of the owner’s death. If the owner died before beginning Required Minimum Distributions (RMDs), the beneficiary must empty the account by the 10-year deadline. If the owner died after RMDs had started, the beneficiary must also take annual distributions during the 10-year period. A surviving spouse beneficiary has more favorable options, including treating the inherited annuity as their own, which allows for continued tax deferral.