An annuity is a contract between an individual and an insurance company under which the individual makes one or more premium payments and the insurer promises to make periodic payments - either immediately or at some future date. The tax treatment of annuity payments depends critically on whether the annuity is held inside a qualified retirement account (in which case all payments are ordinary income) or is a nonqualified annuity funded with after-tax dollars (in which case the investment in the contract is recovered tax-free using the exclusion ratio). Getting this distinction wrong is common - and costly.
Qualified annuity (inside an IRA, 401(k), or pension): All payments are ordinary income. The exclusion ratio does not apply because the original investment was pre-tax. RMD rules apply starting at age 73 (or 75 for those born 1960 or later).
Nonqualified annuity (purchased with after-tax dollars outside a retirement account): Payments are partly a return of investment (tax-free) and partly earnings (taxable). The exclusion ratio determines the tax-free portion. No RMD requirement during the annuity owner's lifetime.
For a nonqualified annuity in payout status (annuitization), IRC §72 allows the owner to recover the investment in the contract (the "cost basis" - after-tax premiums paid) tax-free over the expected payment period. The exclusion ratio equals the investment in the contract divided by the expected return. Each annuity payment is multiplied by this ratio to determine the excludable (tax-free) amount; the balance is ordinary income.
Example: Investment in contract: $100,000. Expected return over life: $250,000. Exclusion ratio: 40%. Annual payment: $15,000. Tax-free portion: $6,000. Taxable portion: $9,000. Once the entire investment is recovered (at the life expectancy date), all subsequent payments are fully taxable.
For nonqualified deferred annuities that have not yet begun making annuity payments, partial withdrawals are taxed on a last-in-first-out basis under §72(e): income first, then return of investment. If a contract has a $100,000 investment and $40,000 of accumulated earnings, the first $40,000 withdrawn is fully taxable as ordinary income. Only after the full $40,000 of earnings is depleted does the return of investment (tax-free) portion begin. This LIFO treatment makes partial surrenders from deferred annuities generally unfavorable from a tax perspective.
Distributions from nonqualified annuities before age 59½ are subject to a 10% penalty under §72(q) on the taxable portion (the income portion, not the return of investment). Exceptions to the §72(q) penalty parallel the §72(t) exceptions for qualified plans: death, disability, substantially equal periodic payments (SEPP), immediate annuities where annuitization begins within one year of purchase, and distributions from an immediate annuity where payments began within one year of the first contribution.
An annuity contract can be exchanged for another annuity contract under IRC §1035 without recognizing gain. The receiving contract takes on the cost basis of the exchanged contract. This allows an annuity owner to move from a high-cost or underperforming contract to a better one without triggering current tax on accumulated earnings. The §1035 exchange must be a direct transfer from insurer to insurer - if the owner receives the proceeds and then purchases the new contract, it is a taxable surrender.