Taxation of annuities involves Internal Revenue Code (Code or IRC), federal Income Tax and Estate Tax and Gift Tax Regulations that further elaborate, describe and address the IRC rules, decisions of the courts, various IRS letters and rulings and other legal and accounting functions, making the taxation of these products voluminous and complex.  This text will only address those situations that are especially important so as to better understand the effect of taxation on these contracts. 

To define a “nonqualified” annuity for tax purposes, it is better to state what it is not.  It is not a tax-qualified pension, profit sharing, or retirement plan or arrangement.37 Premiums that are paid for nonqualified annuities are paid in after-tax dollars, which means that they are not excludable or deductible from gross income for purposes of federal taxation.  Further, the dollar amount of premiums/consideration to a nonqualified annuity is not limited under federal tax law.  Qualified annuities have limits on contributions and federal tax laws provide for deductions or exclusions for such contributions.  Practically, a nonqualified annuity allows a person who has, for instance sold a home or collected a large amount on an insurance policy, etc., to create a savings account through the purchase of such a contract. 

It is rather interesting that the federal tax law does not specifically define what an annuity or an annuity contract is.  What is does is to state certain requirements and then reverts to what an annuity is under state law and insurance company practice.  The tax Code that governs annuities, Code Section 72, also does not actually define an annuity, only stating that the Code Section 72 “applies to payments for a fixed number of years as well as to payments for life.”38

It further provides that contracts under which amounts paid will be subject to the provisions of Section 72 include contracts which are considered to be life insurance, endowment, and annuity contracts in accordance with the customary practice of life insurance companies.  For purposes of Section 72, “it is immaterial whether such contracts are entered into with an insurance company.”39

“Customary practice of insurance companies” relating to annuity products is what has been described in the early part of this text. 

The Code does require that an annuity must provide specified distributions in the event that the “holder” of contract dies.40  A contract will not be treated as an annuity contract if it is held by a “non-natural” person.  Also, in another section which defines a life insurance contract, a variable contract will not be treated as an annuity, endowment or life insurance contract for any period for which the investments made by the separate account on which the contract is based are not adequately diversified according to the regulations.

Other than these negative-type of definitions, it has been left to the courts and the IRS to determine exactly what constitutes an annuity.  In a nutshell, the authorities agree that a contract must provide for periodic payments and the liquidation of principal and earnings through those payments.  The IRS has additional requirements, as one would expect.

Type of Payment Under the Federal Tax Laws

Code Section 72 seems to understand that not all payments from an annuity contract are in the form of annuity payments, such as surrender proceeds that are paid at various times.  Still, the IRS maintains that if the contract is an annuity for federal tax purposes, the party issuing the contract must be obligated to make periodic payments in fixed, or at least determinable, amounts and for a period of more than one year.  This requirement is contained in a typical deferred annuity contract that is issued by a life insurance company wherein there are guaranteed rates at which lifetime annuity payments can be made.

Typically, the annuity contract will specify that payments must begin on or before a certain age of the applicant.  This can raise the question of whether a contract qualified as an annuity if the annuitization date is so far in the future that the possibility of the annuitant receiving benefits or being able to liquidate the investment and income is not possible, or even remote.  This has not been settled presently as originally the IRS did not treat a contract as an annuity when periodic payments were not to begin until the annuitant reached age 95.41  However, in 1983, a contract was treated as an annuity where periodic payments were set to begin when the annuitant became 85, and there has been some indication that a maximum annuitization age of 90 may be accepted. 

Liquidation Requirements for an Annuity for Federal Tax Purposes

The question may arise as to exactly what a contract would be that does not meet the criteria to be considered as an annuity for federal tax purposes.  Since the basic scenario for an annuity to be so classified for tax purposes is that there must be systematic liquidation of the principal and the earnings &/or income thereon.42 Therefore, a contract that purports to be a fixed annuity does not provide for the “systematic liquidation” of investment and interest, would be considered simply as an agreement to pay interest, and not an annuity.  This further is specified in Code Section 72(j) which states that “if any amount is held under an agreement to pay interest thereon, the interest payments shall be included in gross income.”  Further, “An amount shall be considered to be held under an agreement to pay interest thereon if the amount payable after the term of the annuity (whether for a term certain or for a life or lives) is substantially equal to or larger than the aggregate amount of premiums or other consideration.43 



The incremental increases in investment earnings of an annuity contract has never been includible in the gross income of the annuity owner for tax purposes.  Instead, these earnings are deferred until they are distributed via the contract.  This rule has been challenged, naturally, but the general theory of upholding the tax deferral is based upon the belief that the owner of the contract is not in constructive receipt of the periodic increments and thereby realizes no current income.44

However, annuities owned by a corporation or other “non-natural person,” generally are subject to current tax.  Regardless, it is important to remember

F all the investment earnings under an annuity will be taxed eventually, and taxed at ordinary income tax rates.  None of the investment earnings will be exempt from taxation or

taxable at capital gains rates.


A structured settlement annuity is an annuity that is used to provide payments over a period of time to an injured person.  If the structured settlement arrangement abides by certain rules, there can be meaningful benefits in the area of taxation.

If the assignment is a “qualified assignment,” the assignee will not be required to include the lump-sum in his gross income to the extent that the payment does not exceed the cost of “any qualified funding assets”—structured settlement annuities.  Also, the injured party can exclude from their income all the payments he receives as a result of the settlement, but with the security that the payments will be made according to the provisions of an annuity that is issued by a commercial insurer.45 



Federal tax laws state that an annuity contract is considered as deferred if it has not yet passed the annuity starting date—defined as “the first day of the first period for which an amount is received as an annuity under the contract.”46  The IRS defines this as the later of the date at which obligations under contract become fixed; or the first day of the period that ends on the date of the first annuity payment—regardless of the type of periodic payment.47

The IRS definition of a deferred annuity is basically the same as the insurance definition, but there are situations where there is no deferral.

The tax regulations are basically designed to limit the tax deferral of annuities that are used for retirement purposes, and further, to prevent the use of annuities to achieve deferral beyond that time.  Generally, income tax is deferred—no tax due in the current taxable year—in respect to undistributed surrender value of an annuity if the annuity is deferred (as defined above).  The tax deferral applies to the interest credited under a fixed deferred annuity contract, and the dividends, capital gains, and other earnings credited under a variable deferred annuity contract.

Certain rules must be satisfied for tax deferral to apply, such rules are rather extensive and beyond the scope of this text for study in depth.  Some general rules are informative, however.

Note:  The term “holder” is used in the tax regulations and for tax purposes is defined as the person entitled to ownership rights under a contract, therefore, the holder is the named owner of the contract.  If there are multiple owners—such as joint owners—the rules written into the contract must pertain to the death of any one of them.

Deferred Annuities Not Eligible for Tax Deferral

The following annuity contracts are not eligible for income tax deferral:

  1. Annuity contracts not owned by or on behalf of individuals, such as corporations, etc.
  2. Contracts that fail to satisfy certain distribution rules, basically rules pertaining to distribution of proceeds at death.48 
  3. Contracts that provide only for the current payment of interest (discussed earlier).
  4. Variable contracts that are not adequately diversified, or over which the owner possesses investor control, as discussed in the section addressing variable annuities.

If the annuity contract falls within one of these categories, the income earned on the contract each year will be taxable in that year.

Death Benefit Requirements

Code Section 72(s) provides that a contract will not be treated as an annuity for federal tax purposes, unless, with certain exceptions, it provides for certain distribution in the event that the holder of the contract dies.  If these requirements are not met, not only will the deferral not be available, but there will be current taxation on the inside buildup on the contract.  In addition, it is not sufficient for an insurance company to simply comply with these regulations at time of death of the contract holder, it is necessary that this be spelled out in the contract itself.

The requirements, stated briefly, imposed by Code Section 72(s) are:

During Deferral Stage

If any annuity contract holder dies before the annuity starting date, the entire interest in the contract will be distributed within five years after the death of the holder.  Exceptions are

  1. If the designated beneficiary is the surviving spouse, it may be written so that it continues after the holder’s death with the spouse as the new owner.
  2. If the designated beneficiary is an individual, the Code requirement is considered as met in respect to the portion of the annuity payable to such beneficiary if, beginning within one year of the owner’s death, distributions are made over the life of the beneficiary or over a period of life expectancy (calculated according to specific IRS rules).
  3. If the designated beneficiary is a grantor trust, an individual who is treated as owning the assets of the grantor trust is considered the designated beneficiary of contacts held by the trust.  If the beneficiary of an annuity is a non-grantor trust, whether the beneficiaries of the trust can be treated as the “designated beneficiaries” is rather hazy and complex, requiring expert opinion. (Note: “Grantor trust is a trust in which the settler retains control over the trust property or its income to such an extent that the settler is taxed on the trust’s income, [“settler” or settlor, is the person who sets up the trust, a person who makes a “settlement” of property]).
  4. A designated beneficiary will satisfy the requirement if the beneficiary receives a portion of the balance payable under the contract as a series of payments in compliance with the Code, with the remaining balance distributed to the beneficiary within five years of the date of death.
  5. An acceleration of payments scheduled to be made under the five-year rule of the Code or as a series of payments will not violate the Code.



If an annuity holder dies on or after the annuity starting date, the annuity payments may be accelerated, but they may not be distributed at a slower rate.  The slowing of the distribution could be the result of extending the period over which distributions are made, or permitting larger payments to be made in later years.  This does not apply to joint-and-survivor types of annuities which reduce payments after the first annuitant’s death. 

Non-individual Holder

For these tax purposes, if the holder of a contract is not an individual,—such as a corporation of a other non-natural person—the death of the primary annuitant will be treated as the death of the holder.49 The “primary annuitant” is the “individual, the events in the life of whom are of primary importance in affecting or amount of the payout under the contract.”  In addition if the annuity holder is not an individual, a change in the primary annuitant is treated as the death of the holder.50 If the named owner of an annuity is a grantor trust, it is unclear whether the death of the annuitant or the death of the grantor trust would start the distribution rules to be affected.  [Note:  This question can be avoided if the grantor and the annuitant are the same person and changes in the annuitant are prohibited.]

Complex Owner/Holder/Annuitant Arrangements

As stated above, in case of a joint holder of a contract that dies, the distribution rules apply when any of the joint holders dies.  Therefore if there is more than one owner, the entire interest in the annuity must be distributed when the first owner dies. 

If there are joint annuitants, usually the identity of the “primary owner” is not clear, so if the annuity has a non-natural owner and has joint annuitants, generally the required distributions will be made upon the death of the first annuitant to die.  It becomes rather complex where there are joint holders or joint annuitants involved, so care must be taken in drafting the annuity contract’s death benefits as unintended consequences could result.  Again, expert advice is required in these situations.

Continuation of Contract by Surviving Spouse

For tax purposes (Code Section 72(s)) if the surviving spouse is the designated beneficiary, the spouse is considered as the holder of the contract.51  Therefore, the deceased holder’s surviving spouse can continue the contract, or their portion of the contract, as the new owner without taking distributions that would be required if the beneficiary were not the spouse of the holder.  But for this to happen, the spouse must be the designated beneficiary of the annuity and it must make provisions for the spouse to be the new owner.  If the deceased holder was also the annuitant, the contract should provide for a successor annuitant.  (This can be accomplished by a provision in the contract that allows the surviving spouse to be the new annuitant if they elect to continue the contract.)  Interestingly, there are several Code Section provisions and Treasury Regulations that indicate that this surviving spouse exception can only be used one time.  (While there are no published material or guidelines that allows a contract that fails to meet Code Section 72(s) to become corrected, however a contract may be retroactively “corrected” on a case-by-case basis with the IRS.) 



If a contract is held by a corporation or a trust (non-natural person), the contract will not be treated as an annuity contract for tax purposes (except if the corporation is an insurance company).  The annual income on the contract will be treated as ordinary income received currently by the contract owner. 

There are exceptions to this (general) rule for annuities acquitted by the estate of a decedent by reason of the death of the decedent, annuity contracts held by a qualified plan or in connection with a qualified plan, and immediately annuities.  Another exception for annuities held by a trust or other entity as an agent for a natural person.52



F A variable annuity is eligible for the normal income tax treatments of an annuity, provided that the separate account investments that are underlying the contract must be adequately diversified and investor control must be absent.

Diversification Requirements

The tax code states that a variable annuity contract, whether in deferred state or not, will not be treated as an annuity for any period and subsequent period for which the investments made by the separate account under  the contract are not adequately diversified.53  The purpose of this action was to preclude investor control and to enforce rulings relating to investor control.  A segregated asset account is adequately diversified if no more than 55% of the value of the total assets of the account is represented by any one investment, no more than 70% by any two investments, 80% by any three investments, or 90% by any four accounts.  A “segregated asset account” is considered by the Treasury Dept. as adequately diversified and can include subaccounts and those funds managed under some types of asset allocation programs.

For this purpose, all securities of the same issuer are treated as one investment, although each government agency or instrumentality is treated as a separate issuer.54

Note: A variable life insurance contract, but not a variable annuity, can be based on a segregated asset accounting holding US Treasury securities without the percentage limits listed above.

The Look-Through Rule

Subaccounts of a typical variable annuity invest in shares of mutual funds and the subaccount is considered as investing in the securities held by the mutual fund (tax regulations refer to mutual funds as “regulated investment companies” or RICs) and not owning the shares subject to two conditions:  All the beneficial interest in the RIC is held by the insurance company separate accounts; and the public’s access to the RIC is only available through the purchase of a variable annuity or a variable life insurance contract.  This is known as the “look-through” rule.55

The IRS has issued a Revenue Ruling that described the types of qualified pension and retirement plans that are allowed to invest in a RIC without violating the look-through rule.  For instance, direct investment in a fund by a Roth IRA of a SIMPLE IRA will not prevent a separate account from “looking through” to the underlying assets of the fund for the purpose of meeting the diversification requirements of the IRS.  These requirements are quite technical and deal with such items as “fund-of-funds” where there are two layers of funds—the annuity owner (holder) invests in a fund which in turn invests in another fund (Treas. Ruling allowed first layer of funds to be considered as diversified, but the second layer was not, in certain situations).  The federal government has been active in policing this “diversification” requirement as the situation arises, repealing some regulations and installing new ones.  Obviously, if the plan invests in anything other than the typical mutual-fund or similar arrangement, expert advice is necessary as to the tax ramifications.

Control of the Assets

Usually the tax treatment for a deferred annuity will apply to a variable annuity if the separate account assets of the contract must be “considered as” the assets of the issuer of the contract (usually the insurance company).  Therefore, the owner of the contract must not possess “investor control” over the assets underlying the contracts.56

Obviously, the next point is—What is “investor control?  This control occurs when the owner of the contract has the power to direct the custodian of the assets underlying the assets of the contract to sell, purchase or exchange specific assets, and, in some cases, merely has a direct means of influencing the investment of those assets.57If the owner so controls the enjoyment and disposition of the separate  account assets, the owner is then considered as owning the assets for federal tax purposes  As can be expected, there have been many regulations and court decisions regarding the ownership of such assets.

The question now arises as to what control can the owner have over the assets, such as described in the asset allocation and dollar-averaging programs discussed earlier?  Without quoting numerous regulations and court decisions, broadly speaking the rule is that the owner may NOT either:

  1. select or identify any particular investments;
  2. change the terms of the investment guidelines; or
  3. have any legal or equitable, or direct or indirect, interest in the underlying assets themselves.

Also, the owner may not:

  1. select or communicate with the investment advisor regarding the investments underlying the contract, or
  2. have any influence of any kind over the decisions of the investment adviser.

However, the annuity owner may allocate the contract’s premium (consideration) payments and its cash value among several, rather broad, categories of investment options, each option can be represented by an insurance company’s separate account or subaccount that either directly acquires and manages investments or purchases of shares of a mutual fund that is available only through an annuity contract.  The IRS Rulings have specifically permitted an annuity owner to have the option to allocate and premiums and cash values among three broad categories (stock fund, bond fund and money market fund).58 

A recent ruling stated that the investment options available to an annuity owner under the contract were “sufficiently broad” to avoid the problem of investor control where, in this case, the owner could allocate premiums and cash values among some 20 subaccounts, each representing a different investment strategy (which included such varied funds as an international stock fund, a health care industry fund and a fund composed of stock of small companies).  Most analysts and tax experts agree that there does not seem to be any “magic” number of subaccounts, but if the options become too narrow as they are spread under more numerous options, the IRS might want to take a fresh look at it.

Another “hard-and-fast” rule is that if the contract allows the owner to allocate premiums and cash values to a separate account or subaccount that invests directly in shares of a specific mutual fund, these mutual fund shares must NOT be available for purchase by the general public except through an annuity contract.  In the “fund-of-funds” situation (as stated above), the IRS has stated that even though the bottom funds were offered to the public, the applicable Revenue Ruling was not violated, unless if the variable contract owner can allocate premiums or cash values to a subaccount that invests in a single partnership that also allows investment other than through a variable account, the investor control is violated.59 

If a variable annuity does not comply with the diversification or investor control regulations, the contract will not qualify as an annuity and the owner of the annuity will be taxed currently on earnings accruing on the contract’s account values, in some cases, the separate account assets themselves, and the issuer of the contract has withholding and reporting obligations.60  

If a contract that failed to comply with diversification standards wants to correct the situation, they may do so by following IRS guidelines, but the failure must have been inadvertent, corrected within a reasonable time after it was discovered, and the issuer or owner must pay or make adjustments to pay, an amount determine by the IRS base on the amount that would have been due the IRS during the period before it was corrected.


Tax Treatment of Annuity Held by a Trust

It was pointed out earlier that if an annuity is held by a person that is not a “natural person,” the contract will not be treated as an annuity for purposes of the income tax provisions.  But as usually happens, there is a pertinent exception. 

F If an annuity contract is held by a trust or other entity as an agent for a natural person, it is treated as if owned by the natural person and the tax treatment normally applicable to the annuity applies.


If the annuity is owned by a Grantor Trust, the grantor is treated as the owner for federal tax purposes.  If the grantor has attained age 59 1/2 , the grantor will not be liable for the 10 percent penalty tax.  The exception applies to an annuity held by a trust under a pre-need funeral arrangement, where the trust constituted a grantor trust with respect to the customer.61


The trust/agent exception does not apply to all trust-held annuities such as where beneficial interest of a trust-held annuity resides in a non-natural person, to an annuity held by a charitable remainder unitrust.62

Taxable Amount for Deferred Annuity Not Held by or for the Benefit of an Individual

If the annuity is not treated as being held by a person that is not a natural person, the income on the annuity for any taxable year is treated as ordinary income received or accrued by the owner during that taxable year.63 



The tax consequences of transferring an annuity to a trust is that if the deferred annuity contract is transferred without consideration by its natural-person owner to a living trust that operates like a grantor trust under IRS regulations, and such trust was established by the owner of the annuity contract, then no federal estate or gift taxes result from the gift itself.  In addition, the income tax that is normally results from the gift of an annuity will not apply because under the grantor trust rules, there has been no transfer for tax purposes.

Note:  For estate planning purposes, making such a gift of an annuity contract to an irrevocable trust that is established—and is, therefore, not a grantor trust— will have the usual tax consequences when gifting property to such a trust.

A trust can use the funds contributed to it to purchase an annuity without generating any special estate or gift tax consequences.  Care must be taken (and expert advice needed) to structure the arrangement so that it qualifies for the before-mentioned trust/agent exception.



As a general principle, a charitable remainder trust can hold an annuity contract.  A typical situation is where charitable remainder unitrust purchases a deferred annuity, such trust having the net income makeup provision so as to give the trustee flexibility to defer income distributions to the income beneficiary to some later date.  In these situations, there can be a conflict of some state trust laws and federal tax regulations, with the result that the trust may not have to  take this income into account when determining the distribution to the income beneficiary as requested by the trust instrument.

Since there are considerable tax consequences with not only deferred annuities, but principally with charitable trusts themselves, qualification of a trust as a charitable remainder trust can lead to a labyrinth of Treasury Regulations and IRS Code rules, and even IRS Technical Advice Memoranda which are, obviously, too complicated and technical to go into detail here.  Again, if an annuity is proposed to held by a Charitable Remainder Trust, expert advice is required.

Interestingly, the income tax consequences of an annuity being held by a Charitable Remainder Trust is rather simple (ignoring qualification and excise tax questions) as under the regulations the deferred annuity is not treated as an annuity contract in respect to the trust.64Therefore, the trust is treated as receiving the income from the contract for the taxable year.  However, a charitable remaining trust is not subject to tax, except with respect to any unrelated business taxable income that is receives.  Since the income on the contract should not be treated as unrelated business income, thereby taxable, therefore the charitable remainder trust should not be taxable on the income on the contract.65


Generally, an annuity contract held by a corporation or other type of non-natural person will not qualify as an annuity contract for federal income tax purposes (with some exceptions); so if the contract is therefore disqualified as an annuity, the owner (holder) will be taxable on the income from the contract for that taxable year.

One of the exceptions is the trust/agent exception discussed above.  Most of the other exceptions relate to the date of regulations and other technical issues.  The trust/agent exception would apply if, for instance, the acquiring corporation held it as an agent for a natural person who is the beneficial owner of the contract.



1.  If an annuity is NOT a tax-qualified pension, profit-sharing, or retirement plan or arrangement, it is

      A.  a qualified annuity.

      B.  a nonqualified annuity.

      C.  a variable annuity.

      D.  an equity indexed annuity.


2.  All of the investment earnings under an annuity

      A.  will never be taxed.

      B.  will eventually be taxed at capital gains rates.

      C.  will eventually be taxed at ordinary income tax rates.

      D.  is taxed at ordinary income tax rates as earned.


3.  An annuity that is used to provide payments over a period of time to an injured person is called

      A.  an accident annuity.

      B.  a structured settlement annuity.

      C.  a flexible variable annuity with limited benefits.

      D.  an equity indexed annuity.


4.  Federal tax laws state that an annuity contract that has not passed the annuity starting date, is

      A.  considered a defunct.

      B.  considered as an immediate annuity.

      C.  void ab initio.

      D.  considered as deferred.


5.  Code Section 72(s) provides that an annuity contract will not be treated as an annuity for federal tax purposes unless (with certain exceptions) it

      A.  provides for total disbursement at age 75.

      B.  has no death benefits.

      C.  provides for certain distribution in the event of the death of the holder of the annuity.

      D.  is commissionable.


6.  If an annuity holder dies on or after the annuity starting date, the annuity payment may be

      A.  accelerated but may not be distributed at a slower rate.

      B.  distributed at a slower rate, but not accelerated.

      C.  paid to the probate court.

      D.  available in its entirety to creditors.


7.  For federal income tax purposes, if an annuity contract is held by a corporation or a trust, the annual income on the contract

      A.  will be treated as ordinary income received currently by the contract owner.

      B.  will be treated identically as if it were held by an individual.

      C.  will be deferred for tax purposes, until it has been in existence for a minimum of 5 years.

      D.  is reported to the IRS as corporations or trusts cannot own annuities.


8.  The tax code states that a variable annuity contract, whether in deferred state or not, will not be treated as an annuity for any period and subsequent period for which the investments made by the separate account under the contract

      A.  are diversified in any fashion.

      B.  are not adequately diversified.

      C.  are made in mutual fund or mutual fund-type accounts.

      D.  are less than $1000 per month.


9.  If an annuity contract is held by a trust or other entity as an agent for a natural person, the IRS

      A.  will treat it as if were owned by the natural person and taxed accordingly.

      B.  will treat it as if it were held by a corporation and taxed accordingly.

      C.  will never tax the cash value of the contract, except through a probate court.

      D.  will tax all assets at capital gains rates.


10.  With a charitable remainder trust

      A.  the trust should not be taxed on the income of the contract.

      B.  unrelated business taxable income received by the trust is not taxable.

      C.  special permission must be obtained by letter ruling of the IRS as they carefully monitor

            such trusts because of past abuse.

      D.  in order to avoid taxation, all investment income is reverted back to the trustor as non-

            taxable income.



1B     2C     3B     4D     5C     6A     7A     8B     9A     10A