When Is a Flexible Premium Annuity’s Interest Taxed?

A flexible premium annuity is a contract with an insurance company where an individual makes a series of payments over time. The primary tax benefit of this arrangement is tax-deferred growth, meaning that any interest, dividends, or capital gains generated by the funds within the annuity are not subject to federal income tax in the year they are earned. This allows the principal investment and its earnings to compound without the drag of annual tax payments. The accumulated funds are intended to provide income at a later date, typically during retirement.

Unlike other investments, such as savings accounts or brokerage accounts, the owner of a deferred annuity will not receive annual tax forms like a Form 1099-INT or Form 1099-DIV to report the internal gains. The tax obligation is postponed until a distribution is triggered. This deferral is a feature of non-qualified annuities, which are funded with after-tax dollars, and continues as long as the funds remain within the annuity and the owner is a “natural person,” meaning a human being rather than a corporation. Taxation is postponed until money is actually taken out of the annuity contract.

The Principle of Tax-Deferred Growth

The fundamental tax characteristic of a flexible premium annuity during its accumulation phase is tax-deferred growth. This means that any interest, dividends, or capital gains generated by the funds within the annuity are not subject to federal income tax in the year they are earned. This allows the principal investment and its subsequent earnings to compound over time without the drag of annual tax payments.

Unlike other investments, such as savings accounts or brokerage accounts, the owner of a deferred annuity will not receive annual tax forms like a Form 1099-INT or Form 1099-DIV to report the internal gains. The tax obligation is postponed until a future event triggers a distribution from the contract. This deferral is a feature of non-qualified annuities, which are funded with after-tax dollars, and continues as long as the funds remain within the annuity and the owner is a “natural person,” meaning a human being rather than a corporation or other entity.

Tax Reporting for Withdrawals and Surrenders

Taking a distribution from a flexible premium annuity before starting systematic income payments, either as a partial withdrawal or a full surrender, is a taxable event. The taxation of these distributions follows a “Last-In, First-Out” (LIFO) accounting method. This rule dictates that all withdrawals are considered a distribution of taxable earnings first. Only after all the accumulated gain in the contract has been withdrawn does the owner begin to receive their original, non-taxable contributions, known as the cost basis.

For example, if an individual contributed $80,000 to an annuity that has grown to $100,000, the first $20,000 withdrawn would be fully taxable as ordinary income. The insurance company reports these taxable distributions to the owner and the IRS on Form 1099-R. This form details the gross distribution amount and the portion that is taxable.

Owners who take withdrawals before age 59 ½ generally face a 10% additional tax penalty on the taxable portion of the distribution, on top of ordinary income tax. This penalty is intended to discourage the early use of retirement funds. There are several exceptions to this penalty, including if:

• The withdrawal is made after the owner’s death.
• The owner becomes totally and permanently disabled.
• The funds are used for certain qualifying medical expenses.
• The distributions are part of a series of substantially equal periodic payments.

Tax Treatment of Annuitization Payments

When an annuity owner decides to convert their accumulated contract value into a steady stream of income, a process called annuitization, the tax treatment changes. Instead of the LIFO method used for withdrawals, periodic annuity payments are taxed based on an “exclusion ratio.” This method separates each payment into two components: a tax-free return of the owner’s investment and a taxable portion representing the interest earnings.

The exclusion ratio is calculated by dividing the “investment in the contract” (the total premiums paid) by the “expected return.” The expected return is the total amount the owner anticipates receiving over the payment period, which is determined using IRS actuarial tables based on the owner’s life expectancy. The resulting percentage represents the portion of each payment that is excluded from gross income.

To illustrate, assume an owner invested $60,000 in an annuity and is projected to receive a total expected return of $100,000 over their lifetime. The exclusion ratio would be $60,000 divided by $100,000, which equals 60%. If this person receives an annual payment of $5,000, 60% of that payment, or $3,000, would be a tax-free return of principal, while the remaining $2,000 would be taxable ordinary income.

This treatment continues until the owner has recovered their entire investment in the contract. Once the total of the excluded portions of the payments equals the original investment, any subsequent payments received are fully taxable. If the annuitant passes away before recovering their full investment, a deduction for the unrecovered amount may be available on their final income tax return.

Income Reporting After the Owner’s Death

The death of the annuity owner is the final event that triggers taxation of the deferred interest. The tax-deferral privilege does not extend indefinitely beyond the owner’s life, except in specific circumstances involving a surviving spouse. The tax consequences for a beneficiary depend on their relationship to the owner and the distribution method they choose.

If the sole designated beneficiary is the owner’s surviving spouse, they have a unique option. The spouse can elect to treat the annuity as their own, becoming the new owner. This spousal continuation allows the tax deferral to continue uninterrupted, and the funds will be taxed according to the rules that apply to the surviving spouse’s withdrawals or annuitization in the future.

For a non-spousal beneficiary, the tax deferral ends. The beneficiary must begin taking distributions from the contract and will be responsible for paying income tax on the accumulated gain. They must choose between two primary distribution schedules. One option is the “five-year rule,” which requires the entire contract value to be distributed within five years of the owner’s death.

Alternatively, a non-spousal beneficiary can elect to receive the payments over their own life expectancy. To use this “stretch” provision, distributions must begin within one year of the owner’s death. The beneficiary will pay ordinary income tax on the portion of each distribution that represents the untaxed growth in the contract. The insurance company will issue a Form 1099-R to the beneficiary to report the taxable income.