My Comments: This is Part Three and the last one in this series. My hope is you’ve read Part One and Part Two and ready for Part Three of the series and for it to end.  I’ve attempted to provide the reader with a comprehensive and somewhat detailed overview of annuities and how they can be used as a realistic tool to help meet the financial challenges of retirement. Please reach out to me with questions or concerns.

by Tony Kendzior, CLU, ChFC / 1 SEP 2023

Annuity Drawbacks

For all their advantages, annuities also have drawbacks or limitations. These limitations could, for some buyers and in some circumstances, outweigh the advantages, which would make an annuity an unsuitable product for these buyers and/or circumstances.

Annuity drawbacks include:

• lack of liquidity
• Potential contract surrender charges
• tax penalties for early withdrawals
• fees and charges that may be higher than those associated with other investments
• ordinary income tax treatment of distributed funds (as opposed to more favorable capital gains treatment)
• no step-up in basis for beneficiaries
• complex design

The need to educate potential clients about issues of concern

As a professional in this product arena and a fiduciary for over 4+ decades, it’s both my and other agents’ responsibility to be thoroughly aware of all of an annuity’s aspects, good and bad. We must be prepared to help clients measure and weigh all features of an annuity, both pro and con, before an annuity is recommend for sale to someone.  At the same time, responsibility must be accepted to educate potential clients on the “rules” of annuity ownership, and how to avoid the imposition of charges, fees, and penalties when these rules are not followed.

Annuities are distinct from all other financial products and are aptly suited for retirement planning. They can provide tax-deferred growth and guaranteed lifelong income. They can manage longevity risk or living too long, and depending on the type, provide safety of principal and protection from market downturns. They can offer retirement income stability and, if the income is used to cover basic essential expenses, they can protect retirees from spending “too little” during their retirement years.

On the other hand, like all financial products, annuities have their drawbacks. As both critics and proponents of these products point out, one of the most notable shortcoming of an annuity is a lack of liquidity. Once an annuity is purchased, the owner gives up a certain measure of liquidity and flexibility, which equates to loss of control. This is one of the tradeoffs an annuity buyer must make in exchange for the tax advantages and guarantees the product provides.

All annuities offer the option for annuitization, which converts the contract into a liquidation mode and pays a regular income stream to the annuitant. Annuitizing an annuity is not the same as taking withdrawals. It’s usually irrevocable. There is no direct charge by the insurer for annuitizing a contract.

Common Annuitization Options Include:

• fixed period means equal payments are made over a specific period of time selected by the owner or annuitant (5 years, 10 years, 20 years, etc.). If the annuitant dies before the end of the period, his or her beneficiary will receive the same payments for the remainder of the term. All payments stop at the end of the selected payment term.
(This option is also known as a term certain or period certain.)
• fixed amount means the annuitant selects a fixed amount to be paid as well as the payment frequency (monthly, quarterly, annually, etc.). These payments will be made until the annuity fund is depleted. If the annuitant dies before all funds have been paid out, the remainder is paid to the annuitant’s beneficiary.
• life only means the periodic payments are made to the annuitant as long as he or she lives. At the annuitant’s death, all payments cease. This is not a popular option for obvious reasons.
• life with period certain means periodic payments are made to the annuitant as long as he or she lives, but for no less than a specified period of time (five, 10, 20 years, etc.). If the annuitant dies before the end of the period certain, payments will continue for the remainder of that period to the annuitant’s beneficiary. If the annuitant lives beyond the period, payments will be made until the annuitant’s death.
• joint and survivor means that annuitization is based on the joint life expectancy of two individuals (typically, a married couple) with periodic payments made as long as either is living. When this settlement option is selected, the annuitant chooses how much of the payment will continue to the survivor after the first individual’s death. Common choices are 100 percent, 66 percent, or 50 percent.

Once annuitization begins, the owner is faced with different kinds of illiquidity: the contract can no longer accept new premium deposits (though the “yet to be paid out” funds continue to grow as interest is still credited) and, as a general rule, there is no access to the contract’s cash value.

Though the annuity is providing ready cash through regular income payments, which presumably the owner wanted and planned for, its funds have been committed to liquidation. This aspect of annuitization must be discussed thoroughly with a client before any decision is made that would obligate the owner to an irrevocable income plan.

Annuitization Is Not Required

Annuitization offers many benefits, not the least of which is the assurance of a consistent, guaranteed stream of income. However, annuitization is not for everyone and deferred annuity owners should understand that it is not a requirement of their contract; it is simply an option. Once the surrender charge period ends, typically 7 to 10 years, the owner is free to do as he or she wishes with the contract’s funds, without imposition of any insurer charges. I have a client who purchased a specific FIA in order to maximize the death benefit payable to the beneficiary at some point in the future, not as a source of potential income.

However, the insurance company is not the only authority that can, through fees and penalties, control the use or application of an annuity. Just because an annuity contract may have passed its surrender charge period does not mean that all potential pitfalls have been avoided. The federal government can also step in with financial consequences in the event an unwitting annuity owner runs afoul of the tax rules that apply to annuities. At this point, the advice and counsel of a knowledgeable advisor can be of tremendous value.

Though the federal tax code does not provide a comprehensive definition of “annuity,’ the income tax regulations stipulate that for tax purposes an annuity contract is a contract that is recognizable as an annuity under the “customary” practices of insurance companies. In other words, if the life insurance industry considers the contract an annuity, tax law will treat the contract as an annuity.

As a general rule, the following are required in order for a product to be considered an annuity under tax law:

• The contract must provide an option for periodic income payments of more than one year, made at least annually (i.e., annuitization).
• The payments must liquidate the principal applied to provide the periodic payments, along with its interest or earnings.
• The contract must include terms that meet the minimum distribution-at-death requirements of IRC Section 72(5).3 

If a contract is classified as an annuity, it will be taxed as follows:

• During the deferral period (if the annuity has a deferral period), the growth in the annuity’s value as funds accumulate within the contract is not income taxable. For example, a $100,000 investment in an annuity that nets a constant 6 percent annual return over 20 years will grow to $320,700. For an investor in the 30 percent tax bracket (combined state and federal), the same 6 percent return on a fully taxable investment is reduced to 4.2 percent after tax. His or her investment will have accumulated to $227,600 over the same period. The difference-$93,100-is attributed to tax deferral.
• For this reason, deferred annuities can appeal to those in higher tax brackets who seek tax-favored ways to accumulate savings, especially if they anticipate that their tax rate will drop once they reach retirement and they want to access their funds.

Annuities remain one of the few investment vehicles outside of a qualified plan to be given tax-deferred accumulation treatment.

When distributed, annuity funds are subject to tax as ordinary income at ordinary income tax rates (not at the more favorable capital gains rate). This holds true even if the product is a variable annuity and the assets within the annuity are mutual fund or stock fund subaccounts that would otherwise receive capital gains treatment.

Funds that were previously taxed before they were contributed to the annuity will not be taxed again upon distribution. Likewise, any and all before-tax money contributed to the annuity will be taxed upon distribution, such as funds in a traditional IRA annuity.


These are the basic cornerstones of annuity taxation. However, within these basics are potential traps and glitches that, if not understood or recognized, could easily lead to unexpected consequences for annuity owners. (I make no claim to be an authority of this so you should consult with a tax advisor.)

Section 72 of the Internal Revenue Code operates as the rulebook for the tax treatment of annuities, both qualified and nonqualified. Since annuity funds are subject to taxation only when they are taken or withdrawn from the contract, a significant portion of Section 72 focuses on annuity distributions. To that end, Section 72 classifies funds paid from an annuity as either:

• amounts received as an annuity
• amounts not received as an annuity

How such amounts are classified dictates their federal income tax treatment.

Amounts Received as an Annuity

“Amounts received as an annuity” are funds that are paid from a contract that has been annuitized. As we’ve learned, annuitization involves the distribution of an annuity’s funds as a regular income stream to one or more payees, actuarially designed to last for a certain length of time, as and when the owner specifies.

Each annuity payment is considered to consist partly of principal and partly of interest earnings. To the extent that the contract holder did not deduct any of the premiums contributed to the contract (thereby making the contributions on an already-taxed basis), these amounts will be returned tax-free upon annuitization. Amounts that represent interest credited to the contract, which was never previously taxed, will be taxable when received during annuitization. To account for the tax-free return of principal and the taxation of interest earnings, funds paid under an annuitized contract are taxed per an exclusion formula.

The Exclusion Formula

The formula for determining the percentage of the annuity payments that is excluded from tax is fairly simple:

• Investment in the Contract
• Total Expected Return

The “investment in the contract” is the total amount that was contributed to the contract in the form of premiums. The “expected return” is the total amount of the expected annuity payments that will be made to the annuitant. The resulting percentage represents the portion of the annuity payments that is excluded from tax.

Qualified Annuities

If the annuity is a qualified annuity and the premiums contributed to the contract were fully deducted by the contract owner, the exclusion ratio does not apply. That’s because the annuity consists entirely of funds that were never taxed. i.e., nontaxed principal and nontaxed interest earnings. When paid out as annuitized income, the full amount of each payment will be taxable as ordinary income.

If Full Contribution Is Recovered

If an annuitant lives long enough to receive 100 percent of the premiums that were contributed to the annuity, the annuity’s principal will have been fully recovered. Any remaining annuitized payments that are received after that point will consist entirely of interest earnings. As such, they will be fully taxable as ordinary income.

Exceptions to Annuity Aggregation Rule

If any discussion with a client indicates that he or she may be planning to take a distribution from one or more contracts that were purchased in the same year from the same insurer, the producer should advise the client about the aggregation rule. However, there are a few exceptions. The aggregation rule does not apply to the following:

• immediate annuities or annuitized contracts
• immediate annuities and deferred annuities purchased in the same year from the same insurer
• distributions required due to the death of the owner
• contracts issued before October 21, 1988 (unless a pre-October 21, 1988, annuity is exchanged for a new contract, in which case the new contract is subject to the aggregation rule)

My Attempt to Summarize Everything About Annuities

• IRC Section 72 operates as the governing instructions for the tax treatment of annuities, both qualified and nonqualified.
• With the intent to foster annuities for long-term retirement savings, federal tax laws impose taxes and penalties if annuity owners don’t follow the provisions of Section
72.
• If a contract is classified as an annuity, the growth of the annuity’s value as funds accumulate within the contract is not income taxable and, when distributed, annuity funds are subject to tax as ordinary income (not capital gains).
• Annuity distributions classified as “amounts received as an annuity” are annuitized payments, taxed according to an exclusion ratio formula.
• An exclusion ratio apportions each annuitized payment as a nontaxable return of principal and a taxable payout of interest earnings.
• Annuity distributions classified as “amounts not received as an annuity” are withdrawals or distributions that are taxed on a LIFO (last-in, first-out) basis, fully taxing all distributions until the interest credited to the contract is paid out.
• Withdrawals from some annuities are also subject to a penalty tax if taken before the owner’s age 59½.
• There are a number of exceptions to the pre-59½ distribution penalty, identified in IRC Sections 72(t) (which pertains to qualified annuities) and 72(g) (which pertains to nonqualified annuities).
• One pre-59½ penalty exception that applies to both qualified and nonqualified annuities is the substantially equal periodic payment, or SEPP exception, not defined here.

My hope is that you’ve been interested enough in this topic to read to the end. If not, then reach out to me with questions and/or concerns and I’ll do my best to bring you up to speed. Failing that, I have friends or associates whom I trust and I’ll gladly share their names with you.