The Tax Consequences of a Whole Life Annuity

Whole life annuity products offer a way to generate an ongoing source of income that continues for the life of the account holder. Tax consequences for whole life annuities vary depending on the type of annuity plan purchased. Early withdrawals and account transfers from one person to another or one account to another may also incur tax consequences.

Whole Life Annuities

Whether contributing a lump-sum amount, or making contributions on a regular basis, whole life annuities provide an income stream for the life of the account holder or for a set length of time. Whole life annuities involve two stages, known as the accumulation and annuitization, or distribution stages. During the accumulation stage, contributed monies accumulate interest earnings until a maturity date. Once the annuity matures, account holders start receiving regular distributions for life. The two main categories of annuities include qualified and non-qualified. Funding for qualified annuities uses pretax dollars, while funding for non-qualified annuities uses after-tax dollars. The pretax versus after-tax aspect determines which tax rules apply for whole life annuities.

Qualified Annuities

During the accumulation period, whole life annuity account contributions generate interest earnings on a tax-free basis. When comparing qualified and non-qualified accounts, this tax-free component has different effects on what becomes taxable. Because funding for qualified annuities comes from pretax dollars, any amounts withdrawn become taxable. This rule applies in cases where an account holder makes an early withdrawal, or whenever the scheduled distribution stage begins. For both qualified and non-qualified annuities, the tax percentage rate depends on the account holder’s income level at the time of withdrawal or distribution.

Non-Qualified Annuities

Tax consequences for non-qualified whole life annuities carry less of a sting due to the after-tax dollars used to fund them. Any withdrawal or distribution amount consists of money invested into the account and accumulated interest earnings. Taxable amounts follow an exclusion ratio that calculates contributions made versus accumulated interest earnings. The taxable amount corresponds with the amount of interest earnings generated by any contributions made. For non-qualified whole life annuities, partial withdrawals follow a last-in, first-out basis, so the initial distribution payments will consist of mainly interest earnings. This results in larger taxable amounts at the outset. For both qualified and non-qualified annuities, account holders have the option of setting up a distribution schedule that spreads the taxable amount over the length of the distribution period.

Early Withdrawals

Any early withdrawals from a whole life annuity are subject to a 10 percent federal tax penalty when made before the age of 59-1/2. Exceptions to this rule apply for non-qualified annuities in cases where the account holder dies before the age of 59-1/2, and for immediate annuity accounts. Immediate annuity accounts require a lump-sum contribution that’s immediately distributed according to a payment schedule. The tax consequences for surrendering a whole life annuity follow the same guidelines used for early withdrawals. Account transfers can occur from one person to another, from an annuity account to another type of investment account or from the account holder to a beneficiary in the event of death. With non-qualified annuities, a transfer from one person to another (or to another type of account) requires the original owner to pay taxes on any interest earnings made. With qualified accounts, the owner pays taxes on the entire amount transferred. The same rules apply in the case of a beneficiary transfer, except the beneficiary ends up paying the taxes. In the case of qualified accounts, beneficiaries may have a large tax bill to pay since the entire transfer amount becomes taxable with a qualified plan.