Although the income tax rules regarding annuity contracts have been tightened over the past several years, annuities still enjoy a significant tax advantage as vehicles for long-term investment planning and retirement planning. The primary tax advantage is that the amount invested in the annuity contract accumulates on a tax-deferred basis. That means that the income earned on the contract is not taxable until it is received by the contract beneficiary. However, if the annuity contract is held by a taxpayer other than a natural person (such as a trust or corporation) the tax deferral feature will be lost unless the entity holds the contract as an agent for a natural person.

The income taxation of amounts received under an annuity contract involves the taxation of the contract at two separate stages: first, during the accumulation period before the annuity benefit starting date, and second, during the period of actual annuity benefit payments under the contract.

The general rule for taxation of amounts received as loans and withdrawals before the annuity starting date is that such amounts will be taxable to the extent of income earned on the contract. This treatment represents a LIFO type of tax treatment similar to that applied to life insurance policies that are classified as modified endowment contracts. In addition, a 10 percent penalty will generally apply to the taxable portion of such payments, unless the payments are made after the taxpayer reaches the age of 59 l/2 or are made by reason of the taxpayer�s death or disability.

It is important to note that if the taxpayer�s entire investment in the annuity was made prior to August 14, 1982, he or she may receive amounts before the annuity starting date and treat those amounts as a nontaxable return of his or her investment until the amount received exceeds the taxpayer�s basis in the contract. This FIFO method of taxation was the general rule until 1982 tax legislation changed it. Existing contracts were grandfathered by that legislation.

For annuity contracts in which the taxpayer made investments both before August 14, 1982, and after August 13, 1982, income in the contract must be allocated to the appropriate investment period. All income attributable to pre-August 14, 1982, investments receives FIFO tax treatment, and income attributable to post-August 13, 1982, investments receives LIFO tax treatment. These rules generally apply to loans from the contract as well as withdrawals.

To determine the taxation of annuity payments during the actual period when the contract is annuitized, the so-called exclusion ratio applicable to the specific contract must be calculated. The exclusion ratio is the ratio of the amount invested in the contract to the total amount expected to be received under the contract. This fraction is then multiplied by the amount of each annuity payment to determine the amount that represents a nontaxable return of the taxpayer�s investment (the excludible amount). The balance of the annuity payment is includible in the taxpayer�s gross income.

The amount invested in the contract is generally the premium paid minus previous nontaxable distributions, if any. If the annuity provides a period certain or other guarantee feature, the actuarial value of that feature must be subtracted from the amount invested to determine the exclusion ratio.

The amount expected to be received (expected return) under the annuity must also be calculated. If the annuity payments are to be made for the life of an individual, the life expectancy tables in the Treasury regulations must be used to calculate the expected return. If the annuity is for a fixed period of time, the total annuity payments to be received represent the expected return. Special rules apply to the calculation of the exclusion ratio for equity-based (variable) annuity contracts.

Current tax law provides that the full amount of the annuity payment will be includible in the recipient�s gross income once the total of the excludible portion of each payment received equals the taxpayer�s investment in the contract. At that point, basis has been fully recovered. If the taxpayer dies before basis is fully recovered, a deduction is available for the unrecovered basis on the taypayer�s final return. However, if the annuity benefit starting date was before January 1, 1987, a life beneficiary is permitted to use his or her exclusion ratio for life, regardless of whether the total tax-free amounts received are more or less than the taxpayer�s investment in the contract. Correspondingly, no deduction is allowable in such cases if the beneficiary dies before basis is fully recovered.