Florida 2-15 Life, Health and Variable Annuity AgentGeneral Knowledge of Life InsuranceHard
A client purchased a single premium deferred annuity (SPDA) for $150,000. Over 10 years, the annuity's value grew to $200,000. The client then decides to annuitize the contract, electing a life income payout option. How will the payments received from this annuitized contract be taxed?
- AAll payments will be tax-free until the original premium is recovered.
- BEach payment will be partially taxable, with a portion representing a tax-free return of principal and a portion representing taxable gain.
- CThe payments will be taxed as capital gains until the entire gain is distributed.
- DThe entire amount of each payment will be taxable as ordinary income.
Show answer & explanationAnswer & explanation
Correct answer: B. Each payment will be partially taxable, with a portion representing a tax-free return of principal and a portion representing taxable gain.
When a deferred annuity is annuitized, each income payment received is subject to the 'exclusion ratio' rule. This rule determines the portion of each payment that is considered a tax-free return of the original premium (cost basis) and the portion that is taxable income (gain). The exclusion ratio is calculated by dividing the investment in the contract by the expected return.
Why the other options are wrong
- A. This describes the 'cost recovery' method, which is typically used for non-qualified withdrawals, not annuitized payments.
- C. Annuity gains are taxed as ordinary income, not capital gains.
- D. This is incorrect; a portion of each payment is considered a return of the original premium (cost basis) and is tax-free.
Annuity Exclusion Ratio
A formula used to determine the tax-free return of principal and the taxable portion of each income payment received from an annuitized non-qualified annuity.
- Applies to annuitized non-qualified annuities
- Separates payments into principal (tax-free) and gain (taxable)
- Calculated as (Investment in Contract / Expected Return)
- Ensures original premium is returned tax-free over time
Memory trick: Exclude the basis, tax the gain.