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 annuity or how long you held them in your contract.
Total annual payouts are reported to you and to the IRS on Form 1099-R, Distributions from Pensions, Annuities, Retirement, or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Usually, the form will also show your taxable amount so that you do not have to figure it based on the General Rule described earlier.
Taxes at Death
The variable annuity contract may provide that at your death a person you name as the beneficiary of the contract will receive a lump-sum death benefit. Depending on the terms of the contract, when a death benefit becomes payable to a beneficiary, taxes may be due.
Even though this is an inheritance, the beneficiary must pay income tax on the portion of the payment in excess of your remaining investment in the contract. This is the unrecovered part of your cost for the contract that remains the payments and withdrawals you received during your lifetime.
A spouse inheriting a non-qualified variable annuity usually has the option to continue the contract in his or her own name; electing this option prevents the spouse from incurring incur any taxes until he or she actually starts making withdrawals.
However, if the spouse chooses to take a check for the lump sum amount of the death benefit, the earnings become taxable as ordinary income. For more details on this topic, see How are variable annuities taxed at death?
For non-spouse beneficiaries, there are usually two options: receive a lump sum distribution that is taxable (as mentioned above) or set up a non-qualified stretch annuity contract (assuming the carrier offers this type of policy; not all do). The stretch contract closely resembles an inherited stretch IRA and allows beneficiaries to spread out the tax liability by taking only required minimum distributions based on their life expectancy. The distributions must begin within one year after the original account-owner's date of death.
Besides the basic tax rules, there are other issues to consider with variable annuities:
Fees. Variable annuities entail considerable costs in the form of an insurance fee, which covers any guaranteed death benefit as well as an administrative fee. These fees are based on a percentage of the value in the contract and apply year in and year out; they can average about 2% or more annually (depending on the insurance company and other factors). You cannot deduct these amounts as investment expenses; they become part of your cost (investment) in the contract. (Read Getting the Whole Story on Variable Annuities.)
Additional Medicare tax. High-income taxpayers must include the taxable portion of variable annuities in their investment income for purposes of computing the 3.8% additional Medicare tax that applies to net investment income (NII).
Early distributions. As with other tax-deferred accounts intended for retirement, variable annuity withdrawals of any kind – whether a lump sum or a stream of payments – received before you reach age 59½ are subject to a 10% early withdrawal penalty on the taxable portion of the payment. However, the penalty does not apply if you are totally and permanently disabled; nor does not apply to a beneficiary who receives payments on account of your death, regardless of whether you, or the beneficiary, are under age 59½. Some other exceptions to this penalty may apply.
Surrendering the contract. If you surrender the contract, which means cashing it in before you start to receive annuity payments, the portion of the payment representing your investment in the contract is tax-free; any additional amounts are taxable as ordinary income. Usually, there is a significant surrender charge for ending your contract; this charge is not tax-deductible. You cannot take any write-off when the value of the account drops if you continue to hold the contract. However, if you surrender it, you can take an ordinary loss at that time. The loss is the difference between your cost and what you received on the surrender, minus the surrender charge.
Exchanges for other annuity contracts. Instead of cashing in a variable annuity in order to buy one with better terms (e.g., lower annual fees), and paying tax at that time on any increase over your investment, you can transfer to another contract in what is called a 1035 exchange (it’s named after the section in the Internal Revenue Code that permits it). The exchange is tax-free as long as the annuitants are the same in both contracts. The insurance companies can provide you with the paperwork to make the exchange.
Withholding. Withholding on the taxable portion of your annuity payments is automatic, based on a rate that applies to wages as if you are married with three withholding allowances (even if you are single), provided that the insurer has your Social Security number. However, you can opt out of withholding by filing Form W-4P, Withholding Certificate for Pension or Annuity Payments.
The Bottom Line
Variable annuities are attractive from a tax perspective because of the deferral feature that allows you to postpone taxation on your investment gains. However, at some point you, or your beneficiaries, will pay tax on the income earned in the contract. What’s more, all of the tax will be ordinary income rather than the more favorably taxed capital gains if you’d made the same investments in a taxable account rather than through a variable annuity.
When deciding to take a withdrawal from a non-qualified variable annuity or when inheriting money from such accounts, it is important to seek competent tax advice. Making a wrong move could create a hefty tax bill.