The income tax treatment of annuities under § 72 is similar to the taxation of life insurance proceeds received by a beneficiary under a settlement option in that the installment payments in both cases contain return-of-capital and income components. In the case of an annuity contract, the amount paid to the insurer, whether as a single premium or as a series of premium payments, is returned to the annuitant in annual or more frequent installments combined with an interest element, commencing either immediately or at a deferred date and continuing for the annuitant’s life or, if the contract so provides, for the lives of two or more annuitants.
Variable annuities are subject to certain types of taxation.
If the amount to be paid under an annuity contract varies in response to the insurer’s investment experience, cost-of-living indexes, or other fluctuating criteria, the “expected return” cannot be predicted with accuracy; and this in turn makes it impossible to compute an exclusion ratio in the usual manner. The regulations cope with this problem by (1) treating the amount received by the beneficiary as an annuity payment only to the extent that it does not exceed a taxpayer’s investment in the contract (less the value of any refund feature), divided by the number of anticipated periodic payments; (2) applying an exclusion ratio of 100 percent to this amount, thus excluding it from gross income in its entirety; and (3) requiring any additional amounts received to be included in gross income.
How are Variable Annuities Taxed?
Because the amount excluded in any taxable year cannot exceed the larger of (1) the amount actually received or (2) the ratable portion of the taxpayer’s investment, a taxpayer would not recover his investment tax-free if he received less than the excludable amount in any year and lived no longer than his life expectancy. To correct for this deficiency, the regulations permit a taxpayer to elect to recompute the excludable annuity portion of payments received after a shortfall, thus restoring the possibility of recovering his investment tax-free if investment experience under the contract improves.
Variable Annuity Contracts
Variable annuity contracts giving the policyholder control over the insurer’s investment decisions are not treated as genuine annuity contracts subject to § 72. They are taxed as custodial accounts generating income that is includable in the policyholder’s gross income as realized. If, however, the investor merely has the ability to allocate premiums paid among various sub-accounts available under the contract (in none of which any person can invest directly), and does not have the power to control or influence the investments made by the company in any of the sub-accounts themselves, then the contract will be recognized as a life insurance or annuity contract.