Tax Laws for Dividing Annuity in a Divorce

You need to consider the issue of annuity and divorce from the very beginning. Because of the unique structure of annuities, they can be a tricky asset to divide during a divorce.

Annuity owners do not have a separate account at the insurance company, but instead, hold a claim to the terms of a contract in which the annuity company will send them future income according to the contract's terms. Depending on the circumstances, it is sometimes tricky to divide annuity interests into lump-sum payouts, especially if the annuity income stream has already commenced.

Marital vs. Non-Marital Property

The first step in assessing how to divide an annuity in a divorce is to determine whether the annuity is marital property or not. The specific criteria are dependent on state law. However, the general rule is that if one partner owned an annuity before the marriage and no further premiums were contributed to it during the marriage, the original owner retains rights to the annuity.

However, if the annuity was acquired during the marriage, each spouse may have a claim if it is part of the community marital property. Suppose, the annuity were acquired prior to the marriage, but the married couple paid premiums into the annuity. In that case, the second spouse may have a claim to part of the earnings attributable to contributions during the marriage.

Everything depends on what the state considers as marital property. Some states use common law, which states that a property one spouse acquires belongs to that person alone unless both names are on the title or deed.

QDROs on Annuities and Divorce

A qualified domestic relations order (QDRO) is a court order or decree dividing marital assets equitably among two divorcing parties. QDROs have their limitations, however: They cannot award either party in divorce any income or annuity benefit that is unavailable under the terms of the original annuity contract.

For example, if the annuity cannot be cashed out in a lump sum, neither can the courts award a cash payment to the annuitant's divorcing spouse. Instead, the courts can award a share of future income.

However, if the annuity contract allows for lump-sum payments, the divorcing spouse can receive a lump sum rather than a stream of payments.

Taxes and Penalties in Divorce

Typically, the law imposes a ​10 percent​ penalty on distributions from an annuity before one reaches age ​59 ½​. In addition, the person withdrawing the money also has to deal with the immediate payment of any income taxes due on earnings over and above the annuity owner's tax basis in the annuity.

However, there is no tax due on simple transfers of annuity interests from one spouse to another or on transfers to an ex-spouse due to a divorce proceeding.

Tax Basis and Exclusion Ratios

When you take money out of an annuity, you must pay taxes net of the annuity's "exclusion ratio." The exclusion ratio equals the tax basis in the annuity (premium), divided by the future benefits (expected return) expected from the annuity if the annuitant lives to life expectancy. So, the higher the tax basis, the lower the income tax on annuity will be.

When an ex-spouse receives an annuity interest from a former spouse as part of a divorce, she also inherits her ex-spouse's tax basis in the annuity. In this way, she still receives credit for premiums paid into the annuity and is not double taxed on income after having already paid taxes on premium.

While no one marries expecting a divorce, it is something you should think about when investing in annuities. That way, you can split your marital property easily and fairly for both parties.