Life insurance and annuities are related but distinct products issued by insurance companies. Straight life insurance pays a death benefit to beneficiaries upon the death of the insured, whereas annuities pay accumulated benefits to policyholders, and occasionally to their heirs as well. The taxation of life insurance products, including annuities, depends on the type of payment distributed.
Death Benefits
A life insurance death benefit is not taxable to beneficiaries.
Fixed Annuity Payments
Annuities have two distinct phases, the accumulation phase and the annuitization phase. During the accumulation phase, annuities grow on a tax-deferred basis, meaning you do not have to pay current income tax on any gains within the annuity. However, upon distribution during the annuitization phase, gains within an annuity contract are taxed at ordinary income tax rates. As fixed annuities are funded with after-tax contributions, a portion of an annuity distribution is a tax-free return of capital. The Internal Revenue Service, IRS, uses a formula known as the exclusion ratio to determine which percentage of an annuity's distributions are taxable.
Variable Annuity Payments
As with a fixed annuity, variable annuities have accumulation and annuitization periods. However, some fixed annuities are immediate annuities, which begin making payments right after investment, while most variable annuities have long-term accumulation periods. As with fixed annuities, the taxation of variable annuity distributions depends on the exclusion ratio calculation, which divides the amount originally invested by the total value of the annuity. The resultant percentage is the amount that is tax-exempt upon distribution.
Life Insurance Cash Value
Life insurance cash value is taxed in a similar manner to annuities. If the investment in your life insurance cash value policy exceeds the amount you originally invested, the earnings on your investment are taxable at ordinary income rates when you withdraw them. However, depending on the type of contract you own, your taxation policy may differ. For example, most straight life policies are taxed on a first-in first-out basis, meaning your original investment is considered withdrawn first, resulting in no tax liability. However, other types of life insurance, such as modified endowment contracts, are taxed on a last-in first-out basis, meaning your taxable earnings are considered withdrawn first.
Tax Penalties
As annuities are granted tax-deferred growth by the IRS, they are also subject to a 10 percent early withdrawal penalty if you take a distribution before you reach age 59 1/2.
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