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.
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, 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 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
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.
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.