The Internal Revenue Service (IRS) gives preferential tax treatment to variable annuities, which means that your premium grows tax-deferred. However, as with other types of tax-deferred investments, you do have to pay taxes when you make withdrawals and your age has an impact on the amount of tax you pay when you make withdrawals. Variable annuities are deferred annuity contracts and usually have terms of at least four years. Aside from paying taxes, you also pay surrender fees to the annuity issuer if you make withdrawals before the annuity term ends.
You can roll money from a tax-deferred retirement account, such as a 401k, into a variable annuity without having to pay any taxes at the time of the rollover. When you eventually withdraw funds from the contract, you pay ordinary income tax on the withdrawal.
You can also fund a variable annuity with money previously held in taxable accounts. You have to pay income tax on your earnings when you withdraw these funds from the annuity. By comparison, if you invest taxable money in other types of investments, you pay capital gains tax on your earnings rather than income tax. Many investors have income tax rates that exceed the capital gains rate, which means variable annuities result in a higher tax burden than other types of investments.
Variable annuities benefit from the same tax-sheltered status as retirement accounts, but this means that annuity contact holders also have to contend with the same premature withdrawal penalties. Under the federal tax code, you make a premature withdrawal if you withdraw money from a retirement account or a tax-sheltered annuity before you reach the age of 59 1/2. To deter investors from making premature withdrawals, the IRS assesses a 10 percent premature withdrawal penalty. You pay this penalty along with state and federal income tax.
The IRS refers to variable annuities funded with taxable money as non-qualified annuities. Roth individual retirement arrangements (IRAs), like non-qualified annuities, contain after-tax money that grows on a tax-deferred basis. The IRS uses the first-in-first-out (FIFO) method to tax partial Roth withdrawals. This means you get to withdraw your non-taxable principal before your taxable earnings. However, on all annuities issued after 13 August 1982, the IRS uses the last-in-first-out (LIFO) taxation method. This means you must withdraw your taxable earnings before you can access your non-taxable return of premium. Therefore, your non-qualified variable annuity works similarly to a Roth until you start to make withdrawals.
When you buy a non-qualified variable annuity, the IRS classifies your purchase premium as your cost basis. When you make withdrawals, you only pay taxes on the difference between the account value and your cost basis. On most types of investment accounts, when you die, your heirs receive a stepped-up cost basis. If you heirs liquidate the investment, they only pay taxes on the difference between the value of the investment when they inherited it and the sale price. On variable annuities, your heirs do not get a cost basis step-up, which means they pay taxes on the difference between the account value and the original purchase price. Therefore, variable annuities result in more taxes for your heirs than other kinds of securities.