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U.S. Tax Treatment of Annuities

Matthew Ledvina


As with life insurance, annuities are tax-favored investments under the Code. Unlike life insurance, however, the primary income tax benefit of an annuity is derived from the compounding effect of the tax deferral on the investment gains within the contract, rather than the avoidance of income tax, as with investment in a life insurance policy. Generally, under § 72(a), gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract. The income tax effect of an annuity depends, however, on numerous factors, such as whether the tax is being applied to a distribution during the annuity’s accumulation period or annuitization period and whether the distribution occurs after the death of the holder of the annuity contract or after the death of the annuitant (assuming that the holder and the annuitant are different persons).

Section 72: Annuity Contract Defined

To qualify as an annuity, the annuity contract must satisfy the requirements of § 72. An annuity is a contract, generally issued by an insurance company, providing for regular payments to an annuitant and, potentially, to a beneficiary following the annuitant’s death. The Treasury Regulations state that to be considered “amounts received as an annuity,” such amounts should be:

·        received on or after the annuity starting date;

·        payable at regular intervals; and

·        payable over a period of at least one year from the annuity starting date.

 

Further, the total of the amounts payable must be determinable as of the annuity starting date..

Payments may also be considered amounts received as an annuity if they are paid under a variable annuity contract, despite the fact that the total of the amounts payable under the variable contract may not be determinable as of the annuity starting date, if the amounts are to be paid for a definite or determinable time. If, because of positive investment experience in the variable annuity contract or other factors, the payment with respect to the annuity exceeds the investment in the contract (adjusted for any refund feature) divided by the number of anticipated periodic payments, then only part of the payment will be considered an amount received as an annuity. The excess is an “amount not received as an annuity.


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