Tax Facts

517 / What basic tax rules govern other amounts received under annuity contracts (that are not dividends, cash withdrawals, loans or partial surrenders) before the annuity starting date?

The purpose behind the “interest first” rule ( Q 515) applicable to investment in contracts after August 13, 1982 is to limit the tax advantages of deferred annuity contracts to long-term investment goals, such as income security, and to prevent the use of tax deferred inside build-up as a method of sheltering income on freely withdrawable short term investments.

Consistent with this purpose, other amounts that are neither interest payments nor annuities received under annuity contracts, regardless of when entered into, are not treated first as interest distributions, but are taxed under the cost recovery rule. These amounts include lump sum settlements on complete surrender ( Q 587), annuity contract death benefits ( Q 591), and amounts received in full discharge of the obligation under the contract that are in the nature of a refund of consideration, such as a guaranteed refund under a refund life annuity settlement ( Q 545).1

For information on the effect of a tax-free exchange, see Q 518.

1.     IRC § 72(e)(5).

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