Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. These investments grow without incurring taxes until the time funds are taken out of the account, whether by client withdrawals or annuitization. Beneficiaries of a non-qualified annuity may also face certain tax liabilities upon inheriting its assets.
Overview: How Annuities Work
Like any annuity contract, with a variable annuity the insurer promises to pay you an amount in the future, typically beginning at retirement age and for the rest of your life, based on an initial investment you make. The money you put into a variable annuity, which is labeled a premium payment, does not entitle you to a tax deduction at the time you invest; it’s made with after-tax dollars, like adding money to a bank savings account or any investment. The funds are invested in sub-accounts, which are similar to mutual funds: a range of investment options offered by the insurer.
However, earnings generated on the investment choices you make grow tax-deferred, which means there is no tax on them until you take annuity payments beginning at the annuity starting date (a predetermined date that often coincides with your retirement) or when you take distributions before the annuity starting date. (This is in contrast to earnings from non-qualified brokerage accounts, whose dividends and capital gains are taxed in the year the client’s account receives them, whether or not they are taken out as cash or reinvested.) In tax parlance, annuitized payments are called “periodic payments” and distributions that are not annuitized are called “nonperiodic payments.”
The time over which you add your money, make your investments and watch your account balance grow is called the annuity accumulation phase. Once you reach the annuity starting date and begin to receive payments, you enter the payout phase. During this phase, you may receive payments for the rest of your life, or the joint life of you and a beneficiary you name (such as a spouse), or for a fixed period, such as 15 or 20 years. The person entitled to receive benefits during the payout phase is called an annuitant.
Tax on Withdrawals
When an investor initiates a full surrender of a non-qualified variable annuity (whether receiving annuity payments or taking withdrawals before the annuity starting date), the net gain made over the life of the investment become taxable. But the original amounts invested, those premiums, are not (because they were made with after-tax dollars, remember). So a portion of each payment is treated as principal (aka a return of your investment in the contract) – which is tax-free – and earnings on your investment, which are taxed as ordinary income at the taxpayer’s marginal rate.
So how is this calculated? Funds from annuities are treated on a last-in, first-out basis. The total of all premiums in the distribution are considered the cost basis, which is subtracted from the total lump-sum distribution. In the case of annuitized payouts, an exclusion ratio is applied to each payment to determine the tax-exempt amount.
Essentially, the nontaxable portion of each payment is determined by a ratio of your investment in the contract to the account balance. More precisely, the tax-free and taxable portions of annuity payments are figured using a special computation under the General Rule explained in IRS Publication 575. Withdrawals after the annuity starting date that are not periodic payments usually are treated as entirely composed of ordinary income; no allocation is made. Ordinary-income treatment applies, regardless of the type of investments you made through the variable …