United States
Hong KongAnnuities: the exclusion ratio and everything around it
Annuities defer tax on growth and can convert capital into income for life. Annuitized payments are split between return of basis and taxable gain by the exclusion ratio; withdrawals before annuitization come out last-in first-out.
Two axes, and every annuity sits somewhere on both.
When it pays, and what it invests in
| Axis | Options |
|---|---|
| When payments start | Immediate - within a year. Deferred - later |
| What determines value | Fixed - a declared rate. Variable - subaccounts. Indexed - a formula with a floor and a cap |
A single premium immediate annuity converts a lump sum into income now. A deferred variable annuity accumulates first and may never be annuitized at all.
The exclusion ratio
Once annuitized, each payment is part return of your own money and part taxable gain.
The exclusion ratio is the investment in the contract divided by the expected total return. That fraction of each payment is tax free; the rest is ordinary income.
Once basis is fully recovered, payments become fully taxable. If the annuitant dies before recovering basis, the unrecovered amount is deductible on the final return.
Before annuitization, withdrawals come out gain first and are fully taxable, plus a 10 per cent penalty before 59½. That is the opposite of the exclusion ratio treatment and the distinction questions are built on.
Taxation, in one place
- Growth is tax deferred inside the contract.
- Withdrawals before annuitization: last-in first-out, gain taxed as ordinary income.
- Annuitized payments: split by the exclusion ratio.
- All gain is ordinary income, never capital gain - this is the objection to variable annuities for equity exposure.
- No step-up in basis at death for the beneficiary.
- A 10 per cent penalty on gain before 59½, with exceptions.
The fourth point is the one to hold. Equities inside an annuity convert what would have been long-term capital gain into ordinary income, and there is no step-up.
The 1035 exchange
A tax-free exchange of one annuity for another, or of a life policy for an annuity. Not the other way round - an annuity cannot be exchanged for life insurance.
Basis carries over. It is the mechanism for moving a client out of a poor contract without triggering tax, and questions test the direction restriction.
Payout options
Life only pays the most and stops at death. Life with period certain guarantees a minimum number of payments. Joint and survivor continues to a second life. Refund options return unrecovered premium.
More guarantees mean smaller payments. A question describing a client with no dependants and a desire for maximum income is pointing at life only.
When an annuity is the right answer
Longevity risk. A client who will outlive assets under any reasonable withdrawal rate, and who values certainty over legacy, is the case an annuity genuinely solves.
A client with ample assets and a bequest motive is usually not, and the fees and tax treatment are the reasons why.
Dollar limits here are indexed annually and several were changed by recent legislation. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the exclusion ratio?
The investment in the contract divided by the expected total return. That fraction of each annuitized payment is a tax-free return of basis; the rest is ordinary income.
How are annuity withdrawals taxed before annuitization?
Last-in first-out - gain comes out first and is fully taxable as ordinary income, with a 10 per cent penalty before 59½ unless an exception applies.
Do annuities get capital gains treatment?
No. All gain is ordinary income, and there is no step-up in basis at death. That is the main objection to holding equities inside a variable annuity.
What is a 1035 exchange?
A tax-free exchange of one annuity for another, or a life policy for an annuity. It does not work in reverse - an annuity cannot be exchanged for life insurance. Basis carries over.
When is an annuity the right recommendation?
For longevity risk - a client who would outlive their assets under any reasonable withdrawal rate and values certainty over legacy. A client with ample assets and a bequest motive usually is not.