LIFE POLICY TYPES · 6 MIN READ

Annuity Taxation: Section 72 Rules and 1035 Exchanges

Non-qualified annuity taxation lives in IRC Section 72. During accumulation, gains are tax deferred. Lifetime withdrawals are taxed LIFO (gain first), and withdrawals of gain before age 59 1/2 incur a 10 percent penalty under Section 72(q) unless an exception applies — death, disability, immediate annuities, or substantially equal periodic payments (SEPP). SEPP payments must be computed under an IRS-approved method and continue for at least 5 years or until age 59 1/2, whichever is later; modifying them early triggers retroactive recapture of the penalty. Once payments are annuitized, the exclusion ratio (investment in the contract divided by expected return) splits each payment into tax-free return of basis and taxable gain. Basis can never be over-recovered: when it is exhausted, later payments are fully taxable; if the annuitant dies with unrecovered basis, the remainder is deductible on the final return. Ownership and death rules police the deferral privilege. Under Section 72(u), an annuity held by a non-natural person (such as a corporation) generally loses annuity treatment — annual cash value growth is taxed currently as ordinary income — with carve-outs for immediate annuities, trusts acting as agent for a natural person, and qualified-plan ownership. Under Section 72(s), when the owner of a deferred contract dies before annuitization, a non-spouse beneficiary must take the entire interest within 5 years, or begin life-expectancy payments within 1 year of death; a surviving spouse may instead continue the contract as the new owner. Death after annuitization simply requires remaining payments to continue at least as rapidly as the elected method — so a period-certain balance keeps paying the beneficiary. Section 1035 allows tax-free exchanges on a one-way street of tax favorability: life insurance can go to life, endowment, annuity, or qualified long-term care coverage; annuities can go only to annuities or LTC — never back to life insurance, because that would convert taxable annuity gain into a tax-free death benefit. Partial exchanges between annuities qualify if neither contract takes a non-investment withdrawal for 180 days after a direct insurer-to-insurer transfer; in a split exchange, basis allocates pro rata by the cash value moved to each new contract. Contracts issued by the same insurer in the same calendar year are aggregated as one contract when taxing distributions.