An annuity is a contract that requires regular payments for more than one full year to the person entitled to receive the payments, the annuitant, and it can be bought alone or with the help of an employer (IRS, Annuities, a brief description). When payments begin, each one splits into a part that is a return of what was paid in and a part that is income.
That split is the accounting question, and the Code answers it with a ratio rather than a rule about which payments come first.
Two Different Things Are Called an Annuity
The word carries two senses, and this entry is about the contract. In finance and accounting the same word names a timing pattern, a level payment stream at regular intervals, which is a mathematical description and not a product. The two are worked through separately in ordinary annuity and annuity due, and both of those entries say the same thing: describing a payment stream as an ordinary annuity or an annuity due says only when its payments fall.
The contract sense is a product with terms, charges and its own tax treatment. An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-term goals, you buy one by making a single lump-sum payment or series of payments, and in return the insurer agrees to make periodic income payments to you beginning immediately or at some future date (SEC, Investor.gov, Annuities).
The Types the IRS Names
Six are listed, and they are grouped by what varies rather than by who sells them (IRS, Annuities, a brief description):
- Fixed period annuities pay a fixed amount to an annuitant at regular intervals for a definite length of time.
- Variable annuities make payments to an annuitant varying in amount for a definite length of time or for life, and the amounts paid may depend on variables such as profits earned by the pension or annuity funds or by cost-of-living indexes.
- Single life annuities pay a fixed amount at regular intervals during an annuitant’s life, ending on his or her death.
- Joint and survivor annuities pay a fixed amount to the first annuitant at regular intervals for his or her life, and after that annuitant dies a second annuitant receives a fixed amount at regular intervals, which may be the same or different from the amount paid to the first.
- Qualified employee annuities are retirement annuities purchased by an employer for an employee under a plan that meets certain Internal Revenue Code requirements.
- Tax-sheltered annuities are a special annuity plan or contract purchased for an employee of a public school or tax-exempt organization.
The Income Rule, and the Ratio That Softens It
The starting point is inclusion. Except as otherwise provided in that chapter, gross income includes any amount received as an annuity, whether for a period certain or during one or more lives, under an annuity, endowment, or life insurance contract (26 U.S.C. 72(a)(1)).
The exclusion is then defined as a proportion, not as an order of recovery. Gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ratio to that amount as the investment in the contract, as of the annuity starting date, bears to the expected return under the contract as of that date (26 U.S.C. 72(b)(1)).
So every payment carries the same excluded fraction, rather than the early payments being tax free until the investment is used up.
There is a ceiling on the exclusion, and it is a separate rule. The portion of any amount received as an annuity which is excluded from gross income under that paragraph shall not exceed the unrecovered investment in the contract immediately before the receipt of that amount (26 U.S.C. 72(b)(2)). An annuitant who outlives the expected return stops excluding anything, and later payments are fully includible.
Unrecovered investment is defined so that it can be tracked. As of any date it is the investment in the contract, determined without regard to the refund-feature adjustment, as of the annuity starting date, reduced by the aggregate amount received under the contract on or after that date and before the date of determination, to the extent that amount was excludable from gross income (26 U.S.C. 72(b)(4)).
Dying Early Produces a Deduction, Not a Lost Basis
This is the rule that goes unclaimed, and it has two conditions. If, after the annuity starting date, payments as an annuity under the contract cease by reason of the death of an annuitant, and if as of the date of that cessation there is unrecovered investment in the contract, the amount of that unrecovered investment is allowed as a deduction to the annuitant for his last taxable year (26 U.S.C. 72(b)(3)(A)).
Where the contract provides for payments meeting the requirements the refund-feature paragraphs name, the deduction is allowed instead to the person entitled to those payments, for the taxable year in which the payments are received (26 U.S.C. 72(b)(3)(B)). And for purposes of section 172, a deduction allowed under that paragraph shall be treated as if it were attributable to a trade or business of the taxpayer (26 U.S.C. 72(b)(3)(C)), which is what lets it into a net operating loss computation. What that phrase means generally is set out in trade or business.
Annuitizing Part of a Contract Splits It
Where an amount is received as an annuity for a period of 10 years or more, or during one or more lives, under any portion of an annuity, endowment, or life insurance contract, three things follow. That portion is treated as a separate contract for purposes of the section. The investment in the contract is allocated pro rata between the portion from which amounts are received as an annuity and the portion from which they are not. And a separate annuity starting date is determined for each portion from which amounts are received as an annuity (26 U.S.C. 72(a)(2)).
That means one contract can carry two ratios and two starting dates at the same time.
What the SEC Warns About
Two points are worth carrying to a client conversation. An insurance company’s obligations under an annuity contract are subject to its financial strength and claims-paying ability, so if the insurance company has financial difficulties it may not be able to pay (SEC, Investor.gov, Annuities). And withdrawing the contract’s value as a lump sum instead of taking payments may subject the holder to surrender charges, taxes, and tax penalties (SEC, Investor.gov, Annuities).
The growth is deferred rather than exempt. You pay no taxes on any interest or investment gains in your annuity until you withdraw the money, receive income payments, or a death benefit is paid (SEC, Investor.gov, Annuities).
Common Questions
The payments are, in part. Gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract, except as otherwise provided in the chapter (26 U.S.C. 72(a)(1)), and the excluded fraction is set by the ratio of the investment in the contract to the expected return (26 U.S.C. 72(b)(1)).
No. Ordinary annuity and annuity due describe the timing of any level payment stream, and both of those entries say so directly. The contract described here is a product with its own terms, charges and tax treatment. The two senses share a word and nothing else.
The exclusion stops. It cannot exceed the unrecovered investment in the contract immediately before the payment is received (26 U.S.C. 72(b)(2)), so an annuitant who lives beyond the expected return receives fully taxable payments from that point.
In the figures that are not on the statement. The distribution form reports the gross payment and often a taxable amount, but the exclusion ratio depends on the investment in the contract and the expected return as at the annuity starting date, and the running total of what has already been excluded. Where a client changed providers, inherited a contract, or annuitized part of one, those figures live in paperwork rather than in the year’s reporting, and a return prepared without them either overstates income or claims an exclusion that has already run out.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can run a real block of its own return preparation and reconciliation work through a trial task before anything client facing depends on it.
