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

Policy dividends (unless retained by the insurer as premiums or other consideration), cash withdrawals, amounts received as loans and the value of any part of an annuity contract pledged or assigned, and amounts received on partial surrender under annuity contracts entered into after August 13, 1982, are taxable as income to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract (i.e., to the extent there is gain in the contract).¹ To the extent the amount received is greater than the gain, the excess is treated as a tax-free return of investment. In effect, this ordering treatment results in distributions being treated as interest or gains first and only second as recovery of cost. (In addition, taxable amounts may be subject to a 10 percent penalty tax unless paid after age 59½ or the taxpayer’s disability ( Q 523).)

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