Q: Are dividends payable on an annuity contract taxable income?

A: Taxation of dividends under an annuity contract depends on when the contract was purchased.

If the contract was purchased after August 13, 1982, dividends received before the annuity starting date are taxable to the extent the cash value of the contract (determined without regard to any surrender charge) immediately before the dividend is received exceeds the investment in the contract at the same time. If there is no excess of cash value over the investment in the contract (i.e., no gain), further dividends are treated as a tax-free recovery of investment. If the annuity contract was purchased before August 14, 1982, and no additional investment was made in the contract after August 13, 1982, the dividends will be taxed like dividends received under life insurance contracts (generally tax-free until basis has been recovered; see Q 10).[1]

Dividends retained by the insurer as a premium, or other consideration for the contract, are not included in income.[2] Dividends paid but left with the insurer to accumulate at interest would not be considered retained as premium or consideration.

If any investment has been made after August 13, 1982, in an annuity contract entered into before August 14, 1982, dividends allocable to that investment are includable as dividends on a contract entered into after August 13, 1982.[3] Dividends received under an annuity contract with income allocable to earnings on pre-August 14, 1982, and post-August 13, 1982, investments are allocable first to investments made prior to August 14, 1982, then to income accumulated with respect to such pre-August 14, 1982, investments, then to income accumulated with respect to investments made after August 13, 1982, and finally to investments made after August 13, 1982.[4]

Dividends received after the annuity starting date (Q 362) are included in gross income regardless of when the contract was entered into or when any investment was made.[5]

A special exception applies to annuity contracts purchased by a qualified pension, profit sharing or stock bonus plan, an individual retirement account or annuity, or a special plan of a life insurance company for its employees, or purchased as an IRC Section 403(b) tax sheltered annuity (Q 3726).

 

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[1]

. IRC Sec. 72(e).

[2]

. IRC Sec. 72(e)(4)(B).

[3]

. IRC Sec. 72(e)(5).

[4]

. Rev. Rul. 85-159, 1985-2 CB 29.

[5]

. IRC Sec. 72(e)(2)(A).

 

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.