Taxation of Nonqualified Annuities

[beachbum622]

Is the taxable amount of withdrawals from nonqualified annuities calculated on an annual basis or for each withdrawal? For example, if an annuity with a cost basis of $1000,000 and a current value of "$150,000 is surrendered, the taxable amount is obviously $50,000. .
But using the same example of an annuity with a cost basis of $1000,000 and a balance of $150,000, what if an initial withdrawal of $50,000 is made, leaving a balance of of $100,000? The market tanks reducing the balance to $50,000. The annuity is then surrendered for the remaining $50000. What is the taxable amount under these circumstances?

Please assume that the taxpayer is older than 59.5 and all activity occurs in the same calendar year.

 

[Tahoe Ray]

I'm not an accountant and this isn't tax advice however you'll probably want to speak to one if this is an actual case/situation.

It is a very interesting question though and maybe others will chime in as well.

Gains in a non-qualified annuity are taxed on a last in/first out basis (assuming that it was bought in the last 30 years and you're not annuitizing the contract, which would create an income of both gain and principal) so if you took 50k out of a policy worth 150k with a 100k in basis, all 50k is going to be taxable as ordinary income.

Now, here comes the sticky part. If you later surrendered the entire annuity at a 50k loss (100k basis/50k current value), you could turn around and declare that loss on your tax return.

The problem is, where do you declare the loss? Some accountants will say that it should be taken as a miscellaneous deduction (subject to the 2% floor and possibly AMT) while others might be willing to view it as an ordinary loss. It really depends on who you talk to...

You might be able to take the position that if they were done in the same calendar year, one transaction could wash the other out. You then might be on more solid ground in claiming the loss using the more aggressive option (taking it as an ordinary loss) but you would want to discuss that further with someone who knows your specific situation.

As you can see, this is a relatively complex question and like a lot of things in the tax world, there is conflicting guidance and precedent. That's why this question is probably best posed to your CPA.

 

[Drifting]

I don't think this is what you are asking but when you have principal plus some gains, it is an IRS rule that the TAXABLE portion must be withdrawn first. You can't withdraw the untaxable portion FIRST. Uncle Sam is always looking to cut you off at the pass with annuities and this is just one more reason why I hate annuities. I am not an accountant but I own a nonqualified variable annuity that has appreciated over the years. I have taken premature withdrawals out in the past and so that's how I learned about this.

But I have often wondered if the portion that grows tax deferred is reduced as the market declines or does it remain locked in as taxable income.

 

[Tahoe Ray]

I don't think this is what you are asking but when you have principal plus some gains, it is an IRS rule that the TAXABLE portion must be withdrawn first. You can't withdraw the untaxable portion FIRST. Uncle Sam is always looking to cut you off at the pass with annuities and this is just one more reason why I hate annuities. I am not an accountant but I own a nonqualified variable annuity that has appreciated over the years. I have taken premature withdrawals out in the past and so that's how I learned about this.

But I have often wondered if the portion that grows tax deferred is reduced as the market declines or does it remain locked in as taxable income.

Unless your annuity is pre-TEFRA (bought before Aug 14, 1982)

 

[Drifting]

Unless your annuity is pre-TEFRA (bought before Aug 14, 1982)

Yes pre-TEFRA! That's the term I recall hearing them talk about. Some act aimed at getting more of my money!