Tax deferral is a real feature of a nonqualified annuity. It is not the same thing as tax-free growth, and it is not a reason to ignore the contract’s charges. The comments below are a map of official IRS and FINRA material. They are not advice for your return. Rules depend on whether the annuity is nonqualified or sits inside a retirement plan, and on facts this site does not have.

Deferral is a delay, not an exemption

While earnings stay inside a nonqualified annuity, you generally do not report those earnings each year the way you would report interest on a certificate of deposit held in a taxable account. When you take money out, the earnings portion is generally taxed as ordinary income, not as a long-term capital gain. Ordinary income rates are the rates that apply to wages and to interest. A year in which the index credit was calculated from a stock index does not convert the credit into a stock sale. You never owned the stocks. The SEC bulletin is the ownership point; the tax character of the distribution is the IRS point.

IRS Topic 410 is the short official overview of pensions and annuities. Publication 575 is the longer one. Use those, and a tax professional, before you plan a withdrawal. This page does not restate every worksheet in the publication.

Nonqualified withdrawals: income first

A nonqualified annuity is one you buy with dollars that are not already inside an IRA or a qualified plan. If you take an amount that is not received as an annuity — a partial withdrawal or a lump-sum surrender, rather than a series of annuity payments — the taxable portion is generally the earnings, and those earnings come out first. That income-first treatment is the subject of Revenue Ruling 2007-24. The ruling is also the IRS statement that a 1035 exchange fails if the owner receives the check. Both ideas live in the same ruling because both are about what it means for the taxpayer, rather than the insurer, to receive the money.

This site is not going to explain how contracts from before 1982 allocate withdrawals, and it is not going to explain the 12-month aggregation test in a later revenue procedure. Those are specialized rules. If someone tells you that your contract is “grandfathered,” ask a tax advisor to apply the rule to your issue date rather than relying on a general article.

The additional 10 percent tax

If you receive a taxable amount before age 59½, Topic 410 says an additional 10 percent tax may apply to that taxable portion unless an exception applies. The 10 percent tax is on top of ordinary income tax. It applies to the taxable part, not automatically to the whole check. If a withdrawal is partly a return of your own nonqualified premium, the income-first rule means earnings come out before that premium, so a partial withdrawal can be fully taxable even though you still have basis left in the contract.

Exceptions exist. Topic 410 points at them, and the instructions for Form 5329 are where a taxpayer claims one. This site will not list the exceptions. Lists go stale, and they tempt people to apply a workplace-plan exception to a contract that is not a workplace plan. In particular, do not copy the separation-from-service exception onto a nonqualified fixed indexed annuity. Leaving a job does not, by itself, turn a taxable annuity withdrawal into a penalty-free one. If you think an exception fits, read the Form 5329 instructions for that exception’s actual conditions.

Qualified money: the plan’s rules come first

An annuity can be held inside an IRA, a 401(k), or another retirement plan. FINRA’s annuities overview makes the tax point that matters for shopping: an annuity inside a tax-deferred retirement account usually does not give you extra tax deferral. The account was already tax-deferred. You still pay for the annuity’s surrender charges, limits on the index credit, and any rider. Those costs need a non-tax reason — a guarantee you actually want — if the tax reason is already used up.

Required minimum distributions still apply to traditional IRAs and to similar accounts. The IRS required-minimum-distribution page says you generally have to start taking withdrawals when you reach age 73. It also says Roth IRA owners are not required to take those distributions while they are alive. This page stops at 73. It does not add a later age. A contract’s surrender charge does not cancel an RMD. If the free-withdrawal provision is smaller than the RMD, you can owe a surrender charge on a withdrawal the tax law requires. Ask that question before you put IRA money into a long surrender schedule. The way to fix a missed RMD is an IRS topic of its own; do not look for the fix on an insurance website.

1035 exchanges and replacements

Section 1035 of the Internal Revenue Code can allow a tax-free exchange of one annuity for another annuity when the transaction is done as an exchange between insurance companies. Revenue Ruling 2007-24 holds that if the owner receives the check, the transaction is not a 1035 exchange. The practical instruction is simple: do not have the surrender check sent to yourself if you are trying to move the contract without current tax. The insurers have to handle the transfer. A producer who tells you to deposit the check and write a new one is describing a taxable distribution, not an exchange.

A valid 1035 exchange avoids current income tax on the built-up gain. It does not avoid surrender charges on the old contract, and it does not keep the old contract’s surrender schedule from ending. FINRA warns that replacing an annuity can start a new surrender-charge period. You can defer the tax and still lose economic value to the charge, to a new schedule, or to a less favorable renewal cap. Tax-free is not cost-free.

Exchanging an annuity for a life insurance policy is a different question, and exchanging into or out of a qualified account has plan rules layered on top. Publication 575 and a tax advisor are the right next stop. This site does not describe those combinations as if they were automatic.

What deferral is worth depends on facts you have

Deferral is more useful when you would otherwise pay tax on interest each year, when you expect to take the money in a later year, and when the contract’s limits and charges do not eat the advantage. It is less useful, as FINRA notes, when the dollars are already inside an IRA. It is actively costly if you pay the additional 10 percent tax because you needed the money before 59½ and no exception applies. None of those sentences is a personal conclusion. They are the questions to write next to the illustration.

State income tax can apply as well. This site does not survey state codes. Death benefits have their own income-tax rules for the beneficiary, and those rules are not the same as a step-up in basis on a stock. Do not assume the beneficiary inherits the contract free of income tax on the earnings. Publication 575 discusses annuity income, including after death, in more detail than a marketing summary will.

Sources

Not advice. IndexedAnnuity.com is not an insurance company, agency, broker-dealer, or tax advisor. Nothing here is a recommendation to buy, hold, or replace a contract. Guarantees exist only in a specific contract and depend on the insurer’s ability to pay. Products and state laws differ. Read the contract.
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