503 / What is a variable immediate annuity?

With regard to the taxation of annuity payments made under a variable immediate annuity (or a deferred contract that has been annuitized under a “variable payout option”), it would not be feasible, or equitable from a revenue standpoint, to apply the regular annuity rules in taxing such payments. If investment experience were very favorable, for example, the application of a constant exclusion ratio would result in a correspondingly increased tax-free portion.

Treasury regulations, therefore, provide special rules for taxing variable annuities. However, for taxable years beginning after December 31, 1983, a variable annuity contract will not be treated as an annuity and taxed under these rules unless the underlying investments of the segregated asset account are adequately diversified.¹ (See Q 550.)

In general, these rules provide that the amount which can be excluded from gross income in a taxable year is the portion of the investment in the contract which is allocable to that year. This is determined by dividing the investment in the contract by a multiple taken from the annuity tables which represents the anticipated number of years over which the annuity will be payable.² All amounts received in excess of this yearly exclusion are fully taxable. The amount so determined may be excluded from gross income each year for as long as the payments are received if the annuity starting date was before January 1, 1987.

In the case of an annuity contract with a starting date after 1986, the amount determined may be excluded from gross income only until the investment in the contract is recovered.³