Tax Treatment of Variable Annuity Contracts

The tax rules for variable annuities differ depending on whether you're in the accumulation phase, the annuity phase, or surrendering the contract.

Tax Treatment During the Accumulation Period

• Earnings in a variable annuity grow tax-deferred - no current income tax on dividends, interest, or capital gains within the subaccounts
• There is no annual contribution limit for non-qualified variable annuities (unlike IRAs or 401(k) plans)
• The tax basis (cost basis) of a non-qualified annuity = total after-tax premiums paid into the contract

Taxation of Withdrawals During Accumulation

Partial withdrawals from a non-qualified annuity are taxed on a LIFO (last-in, first-out) basis:

• Earnings come out first and are taxed as ordinary income
• Only after ALL earnings have been withdrawn can the owner withdraw the cost basis tax-free (return of premium)
• 10% early withdrawal penalty applies to the taxable portion of withdrawals taken before age 59 1/2

Example: You invested $100,000 and the contract is now worth $140,000. If you withdraw $20,000:

• The entire $20,000 is taxable as ordinary income (it comes from the $40,000 in earnings first under LIFO)
• If you are under 59 1/2, you also owe a 10% penalty ($2,000) on the taxable amount

Exam Tip: Gotchas

• LIFO means earnings come out first. Many candidates expect FIFO (basis returned first), but annuity withdrawals work the opposite way: all taxable earnings must be withdrawn before you touch your tax-free basis.

Tax Treatment During the Annuity Period (Annuitization)

Once annuitized, each payment is split into a taxable and non-taxable portion using the exclusion ratio:

• Exclusion ratio = cost basis / expected return (total expected payments over the annuitant's life expectancy)
• The non-taxable portion of each payment = exclusion ratio x payment amount (this is the return of basis)
• The remaining portion is taxable as ordinary income

After Full Basis Recovery

• After the cost basis has been fully recovered, 100% of each payment becomes taxable as ordinary income
• If the annuitant dies before recovering the full cost basis, the unrecovered basis is deductible on the annuitant's final tax return

Taxation at Surrender of Contract

• Upon full surrender (cancellation): taxable gain = surrender value - cost basis
• The entire gain is taxed as ordinary income (NOT capital gains, regardless of holding period)
• The 10% early withdrawal penalty applies if the owner is under age 59 1/2
• Surrender charges reduce the amount received but do NOT reduce the taxable gain for tax calculation purposes

Exam Tip: Gotchas

• Surrender charges reduce your check but NOT your tax bill. If your contract is worth $100,000, your basis is $60,000, and you pay a $5,000 surrender charge, you receive $95,000 but are taxed on the full $40,000 gain.

Qualified vs. Non-Qualified Annuities

Exam Tip: Gotchas

• Qualified annuity withdrawals are 100% taxable. There is no LIFO distinction because all contributions were pre-tax, so the entire distribution is ordinary income.

Always Ordinary Income

Regardless of the source of gains (equity subaccounts, bond subaccounts, or any other investment), variable annuity gains are always taxed as ordinary income. This is true even if:

• The gains came from equity subaccounts held for years
• The gains would have qualified for long-term capital gains treatment if held outside the annuity
• The contract was held for decades

Exam Tip: Gotchas

• Variable annuity gains are ALWAYS ordinary income, never capital gains. Candidates often assume long-term capital gains treatment applies to equity subaccounts held for years. It does not.