Owners of annuities often take dividends, make cash withdrawals, or take other amounts out of their annuity contracts before the annuity starting dates. Such amounts are taxable as income to the extent that the policy cash value exceeds the investment in the contract—this results in a Last In, First Out (LIFO) type of treatment where all interest/growth is taxed before any tax-free return of capital payments can occur.
This interest first rule was imposed to discourage the use of annuity contracts as short term investment vehicles. Under this rule, a loan is treated as if it were a cash withdrawal.
Likewise, to the extent the owner uses a contract as collateral for a loan, the owner will be taxed on the amounts borrowed (to the extent that the amount received is less than or equal to the gain inherent in the contract). If the amount received exceeds the built in gain, the excess of what was borrowed over potential gain is considered a tax-free return of the contract owner’s investment. With respect to contracts entered into after October 21, 1988, amounts borrowed increase investment in the contract to the extent they are includible in income under these rules.
In applying the interest first rule, all contracts entered into after October 21, 1988 and issued by the same company to the same policyholder during any twelve-month period are treated as one contract.
When an owner makes a partial withdrawal from the contract and takes a reduced annuity for the same term, a portion of the amount withdrawn will be subject to income tax.
When an owner makes a partial withdrawal from the contract (allocable to an investment in the contract made after August 13, 1982) and chooses to take the same payments for a different term, to the extent the cash surrender value of the contract exceeds the investment in the contract, gain will be realized in the form of a taxable withdrawal of interest.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM