Taxation Issues - Tax Treatment of Variable Annuity Contracts

Tax-Deferred Earnings
While annuities are in the accumulation phase, no taxes are due on the earnings. So, all dividends, interest and capital gains are automatically reinvested without incurring local, state or federal taxes. However, once withdrawn, all earnings are taxed as ordinary income

Annuity Withdrawal Taxation
If investors withdraw from an annuity prior to age 59 ½ a 10% tax penalty on the earnings is imposed. There are exceptions to this penalty, similar to those for IRAs, for withdrawals due to death, disability, etc.

Annuity withdrawals are taxed on a last in, first out (LIFO) basis, so earnings are taxed first as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable. This applies when withdrawing lump sum amounts. However, if you take one of the lifetime payouts, or payout over a specific number of years, the withdrawals are taxed differently.

  • Each payment is considered one part principal (non-taxable) and one part rate of interest (taxable).
  • Each payment is adjusted by an exclusion ratio, which is a ratio that describes the relationship between the invested amount and the total expected return under the annuity contract.

Tax-Free "1035" Exchanges
Section 1035 of the U.S. tax code allows the owner of an annuity to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in the current variable annuity account. The process is similar to a direct transfer from one IRA custodian to another. Section 1035 tax-free exchanges are permitted for life insurance policies as well as annuities.

Variable Life Insurance Taxation
Earnings from a variable life policy are tax-deferred until withdrawn. The earnings are then taxed only to the extent that they exceed the premiums paid into the policy. However, if death benefits are paid out upon the death of the policyholder, the cash value is included in the owner's gross estate and is not taxed as ordinary income.

Policy loans are permitted from variable life insurance policies. Such loans represent a way to withdraw money from the contract without triggering income taxes on the policy earnings.

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