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Tax Treatment of Variable Annuities

Variable Annuities are generally a tax favored investment product when purchased by an individual on a non-qualified basis. Variable Annuities purchased as part of a qualified retirement plan such as an IRA, 401(k), TSA - 403(b) or Deferred Compensation Plan - 457 are taxed under the special tax provisions governing that qualified retirement plan.

Required Distributions

To be taxed as an annuity under Section 72(s) of the IRS Code all non-qualified annuity contract must contain the following two provisions;

  • If the owner of the annuity begins withdrawing money from the annuity and dies, the policy must allow withdrawals to continue at the same rate or faster.

  • If the owner of the annuity dies before withdrawals have begun and the beneficiary of the annuity is the spouse of the owner, the annuity may be continued with the spouse as the new owner.

    If the owner dies before withdrawals have begun and beneficiary is not the spouse of the owner then; a) the entire value of the contract must be distributed within five years of the owners death or b) beginning within one year of the date of the death of the owner the beneficiary may elect to begin distribution of the proceeds over his life expectancy.

Taxation of Annuities

If the owner of the annuity is a person, not a business entity, then increases in value of the annuity contract are not taxed until a distribution occurs by withdrawing all or part of the annuity value or selecting an annuity payout option. In addition if you assign or pledge any portion of the value of your annuity contract it will generally be treated as a distribution. The taxable portion a of a distribution is taxed as ordinary income.

If the contract is owned by other than a natural person such as a business entity then the increase in value over the investment in the annuity must included as income during the year.

Withdrawals

Withdrawals, including systematic withdrawals, from a non-qualified annuity, under Code Section 72(e), are first treated as taxable income if at the time the withdrawal is made the value of the annuity is greater than the "investment in the annuity."

In the case of a full withdrawal from an annuity contract taxes are paid only on the gain above the "investment in the annuity."

Penalty Tax on Premature Distributions

Distributions from a non-qualified annuity prior to age 59 1/2 are subject to a penalty equal to 10% of the amount treated as taxable income.

However there are no penalties on distributions:

  • Made after the taxpayer reaches ages 59 1/2.

  • Made on or after the death of the owner of the annuity. If the owner is not an individual then the death of the primary annuitant.

  • If the taxpayer became disabled.

  • A part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of the taxpayer and his or her designated beneficiary;

  • Made under an annuity contract that is purchased with a single premium when the annuity starting date is no later than a year from purchase of the annuity and substantially equal periodic payments are made, not less frequently than annually, during the annuity period;

  • Made under certain annuities issued in connection with structured settlement agreements.

Taxation of Death Benefit Proceeds

Amounts withdrawn because of the death of the owner of the annuity or annuitant are taxed as a full withdrawal. The gain over the "investment in the annuity" is taxed as ordinary income. Proceeds that are withdrawn under a payout option are taxed the same way as annuity putouts.

In General

The information above is based on our understanding of the tax code and dose not address state taxes. Keep in mind that the tax code is always subject to change. Seek the advice of a tax advisor for a complete understanding of how the tax code applies to you specific situation.


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