512 / What general rules govern the income taxation of payments received under annuity contracts?

All “amounts received” under an annuity contract are either “amounts received as an annuity” or “amounts not received as an annuity.”

“Amounts received as an annuity” (annuity payments) are taxed under the annuity rules in IRC Section 72. These rules determine what portion of each payment is excludable from gross income as a return of the purchaser’s investment and what portion is taxed as interest earned on the investment. They apply to life income and other types of installment payments received under both immediate annuity contracts, and deferred annuity contracts that have been annuitized ( Q 527 to Q 546).¹

Payments consisting of interest only are not annuity payments and thus are not taxed as “amounts received as an annuity.” Periodic payments on a principal amount that will be returned intact on demand are interest payments.² Such payments, and all amounts taxable under IRC Section 72 other than regular annuity payments, are classed as “amounts not received as an annuity.” These include amounts actually received as policy dividends, lump sum cash settlements of cash surrender values, cash withdrawals and amounts received on partial surrender, death benefits under annuity contracts, a guaranteed refund under a refund life annuity settlement,³ and policy loans, as well as amounts received by imputation (annuity cash value pledged as collateral for a loan). “Amounts not received as an annuity” are taxable under general rules discussed in Q 515 and Q 523. The taxation of distributions from life insurance policies is discussed in Q 10 and Q 13.

Except in the case of certain annuity contracts held by non-natural persons ( Q 513), income credited on a deferred annuity contract is not currently includable in a taxpayer’s income. There is no specific IRC section granting this “tax deferral.” Instead, it is granted by implication. The increase in cash value of an annuity contract, other than by application of dividends, is neither an “amount received as an annuity” nor an “amount not received as an annuity.” As a result, an increase in cash value is not a distribution and is not includable in the taxpayer’s income, except where the IRC specifically provides otherwise ( Q 513).

IRC Section 72 places a penalty on “premature distributions” ( Q 523).

Contracts issued after January 18, 1985 have post-death distribution requirements ( Q 593). These post-death distribution requirements also apply to contributions made after January 18, 1985, to contracts that were issued before that date. Contracts issued before January 18, 1985, with contributions that were made before that date are not subject to post-death distribution requirements.

The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of life insurance death proceeds. However, the rules for taxing such payments are similar to the IRC Section 72 annuity rules ( Q 63 to Q 79). On the other hand, as noted earlier, death proceeds under an annuity contract (i.e., from some form of guaranteed death benefit) are taxed as amounts not received as an annuity ( Q 515, Q 523).

Employee annuities, under both qualified and nonqualified plans, and periodic payments from qualified pension and profit sharing trusts are taxable under IRC Section 72, but because a number of special rules apply to these payments, they are treated separately ( Q 3532 to Q 3539, Q 3939 to Q 3973, Q 4083).

Annuity with long-term care rider. Under the Pension Protection Act of 2006, qualified long term care insurance can be provided as a rider to an annuity contract, beginning after December 31, 2009.