Harold, 55, owns a non-qualified annuity with $80,000 basis and $120,000 value. He withdraws $20,000, expecting part to be tax-free. Under the LIFO rule, earnings come out first. The entire $20,000 is taxable. And at 55, he owes a 10% early withdrawal penalty, $2,000 on top of the income tax.
An annuity is a contract between an individual and an insurance company. The insurer promises periodic payments at a future date, for a fixed period or for life. Annuities serve two functions: tax-deferred accumulation and guaranteed income.
Two phases:
- Accumulation: owner contributes, value grows without current taxation on earnings
- Annuitization: insurer converts accumulated value into a periodic payment stream
Three types based on how returns are credited:
- Fixed annuity: guaranteed interest rate. Insurer bears investment risk. Predictable growth.
- Variable annuity: owner allocates to subaccounts (like mutual funds). Owner bears investment risk. Insurers charge a mortality & expense (M&E) fee to fund the guaranteed death benefit and the annuitization...
- Fixed indexed annuity: credits interest based on an index (e.g., S&P 500), subject to a participation rate and a cap. Floor (typically zero) protects against losses.
Common mistakes
- Applying the exclusion ratio to partial withdrawals. The exclusion ratio applies only during annuitization. Partial withdrawals use LIFO. Trap: if Harold's basis ratio is 66.7% ($80,000 / $120,000), the exam offers $6,660 as taxable (20,000 x 33.3%). Correct answer: $20,000, fully taxable under LIFO.
- Attempting a 1035 exchange from annuity to life insurance. Life-to-annuity is permitted. Annuity-to-life is not. The exam describes a client wanting to convert annuity value into a tax-free death benefit, an appealing strategy the code prohibits. Trap: "execute a 1035 exchange to whole life."
- Forgetting the 10% penalty for clients under 59-1/2. When the question provides age below 59-1/2, the penalty applies to the taxable portion. Trap: computing only income tax ($14,400) when the correct total includes the penalty ($14,400 + $6,000 = $20,400).
Bottom line
- Non-qualified partial withdrawals = LIFO (earnings first, fully taxable until all gain is withdrawn); 10% penalty on the taxable portion if under 59-1/2 (exceptions: death, disability, SEPPs)
- Non-qualified annuitization = exclusion ratio (investment in contract / expected return = tax-free fraction)
- Qualified annuities (IRA/401(k)) have no basis, so 100% taxable; non-qualified carry basis equal to after-tax premiums
- 1035 exchange: annuity-to-annuity and life-to-annuity OK; annuity-to-life is prohibited
Exam shortcut
For non-qualified withdrawal questions: calculate the gain (value minus basis). If the withdrawal is within the gain, it is fully taxable under LIFO. If it exceeds the gain, only the gain portion is taxable. Then check age, under 59-1/2 means the 10% penalty hits the taxable amount. "LIFO for Lump sums, Exclusion for Equal payments". L for L, E for E. "Life flows DOWN to Annuity".
The full lesson (about 2,209 words, 15 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- C.22
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