Tax Treatment of Variable Annuity Contracts

Every one of these rules traces back to the same principle: a variable annuity defers tax on growth but never converts that growth into a capital gain, no matter how it exits the contract.

How Are Earnings Taxed 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

How Are Withdrawals Taxed 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• Only after ALL earnings have been withdrawn can the owner withdraw the cost basis tax-free (return of premium)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% IRS early withdrawal penalty generally applies to the taxable portion of withdrawals taken before age 59 1/2, unless an exception applies

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 and no exception applies, 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expect FIFO (basis returned first), but annuity withdrawals work the opposite way: all taxable earnings must be withdrawn before you touch your tax-free basis.

How Are Payments Taxed 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
• Qualifying substantially equal periodic payments, made at least annually over life or life expectancy, are exempt from the 10% IRS penalty before age 59 1/2. Annuitization alone does not automatically remove the penalty

What Happens 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

How Is Surrender of the Contract Taxed?

• Upon full surrender (cancellation): taxable gain = surrender value - cost basis, where surrender value is the amount the owner actually receives
• The entire gain is taxed as ordinary income (NOT capital gains, regardless of holding period)
• The 10% early withdrawal penalty generally applies to that taxable gain if the owner is under age 59 1/2 and no exception applies
• Surrender charges reduce the amount received, so on a full surrender they also reduce the taxable gain

Exam Tip: Gotchas

• Measure a full-surrender gain from the check, not the contract value. If your contract is worth $100,000, your basis is $60,000, and you pay a $5,000 surrender charge, you receive $95,000 and are taxed on $35,000, not $40,000.

How Do Qualified and Non-Qualified Annuities Differ?

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.

Why Are Gains 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.

What Should You Check on Exam Day?

• Confirm LIFO applies to non-qualified withdrawals: earnings out first, taxed as ordinary income, before any tax-free basis.
• Use the exclusion ratio (cost basis / expected return) only for annuitized payments, not for pre-annuitization withdrawals.
• On a full surrender, subtract cost basis from the amount actually received, after any surrender charge.
• Skip LIFO analysis entirely for qualified annuities; the full distribution is taxable since contributions were pre-tax.
• Apply the 10% IRS early withdrawal penalty only to the taxable portion when the owner is under 59 1/2 and no exception applies; contractual surrender charges are separate.