515 / What basic tax rules govern dividends, cash withdrawals, loans and partial surrender amounts received under annuity contracts before the annuity starting date?

For the purpose of determining the taxable portion of a partial surrender, cash surrender value is determined without regard to any surrender charge.² This is not the case with regard to total surrenders ( Q 587). Investment in the contract is, under the general rule, reduced by previously received excludable amounts. However, if annuity loans are involved, investment in the contract is increased by loans treated as distributions to the extent the amount is includable in income, although not reduced to the extent it is excludable.³

Policy dividends, cash withdrawals, and amounts received on partial surrender under annuity contracts entered into before August 14, 1982 (and allocable to investment in the contract made before August 14, 1982) are taxed under the “cost recovery rule.” Under the cost recovery rule, the taxpayer may receive all such amounts tax-free until the taxpayer has received tax-free amounts equal to his or her pre-August 14, 1982 investment in the contract; the amounts are taxable only after such basis has been fully recovered.⁴

Amounts received that are allocable to an investment made after August 13, 1982, in an annuity contract entered into before August 14, 1982, are treated as received under a contract entered into after August 13, 1982, and are subject to the “interest first” rule.⁵ If an annuity contract has income allocable to earnings on pre-August 14, 1982 and post-August 13, 1982 investments, the amount received is allocable first to investments in the contract made prior to August 14, 1982, then to income accumulated with respect to such investments (under the “cost recovery” rule), then to income accumulated with respect to investments made after August 13, 1982, and finally to contributions made after August 13, 1982, under the “interest-first” rule.⁶

Where, as part of the purchase of a variable annuity, a taxpayer entered into an investment advisory agreement that stated that the company issuing the annuity would be solely liable for payment of a fee to an investment advisor who would manage the taxpayer’s funds in the variable accounts, the fee was considered to be an amount not received as an annuity and, thus, includable in the taxpayer’s income to the extent allocable to the income on the contract.⁷

For tax years after 2009, a charge against the cash surrender value of an annuity contract or life insurance contract for a premium payment of a qualified long-term care contract ( Q 477) that is a rider to the annuity or life contract will not be included in the gross income of the taxpayer. The investment in the contract for the annuity or life contract will be reduced by the amount of the charge against the cash surrender value.⁸ For more information on the tax treatment of other amounts received under an annuity contract before the annuity starting date, see Q 517. For information on the effect of a tax-free exchange, see Q 518.

Special rules applicable to amounts received under pension, profit sharing, or stock bonus plans, under annuities purchased by any such plan, or under IRC Section 403(b) tax sheltered annuities are discussed in Q 613, Q 3968, and Q 4083. The rules applicable to loans under qualified plans and under tax sheltered annuity (IRC Section 403(b)) contracts are discussed in Q 3948 and Q 4058, respectively.