587 / What are the income tax consequences when the owner of an annuity contract takes the lifetime maturity proceeds or cash surrender value in a lump sum cash payment?
The investment in the contract is the aggregate premiums or other consideration paid for the annuity minus amounts paid out that were excluded from income (and/or any dividends received).3 The gain is ordinary income, not capital gain, and thus cannot be netted against capital losses.4
Some commentators and some insurers have taken the position that the gain on total surrender of a deferred annuity equals the cash value prior to surrender, without regard to surrender charges,5 less the taxpayer’s investment in the contract.
Example: John’s deferred annuity has a current cash value of $110,000, to which a surrender charge of $10,000 applies. His investment in the contract is $100,000. The position described above holds that if John surrenders the contract now for its net surrender value of $100,000, he will recognize a gain of $10,000 (the cash value of the contract prior to surrender, without regard to surrender charges, less his investment in the contract).
This application of Section 72(e)(3)(A) is incorrect; it applies only in the case of partial surrenders. In the case of a full surrender, IRC Section 72(e)(5) states that in the case of “full refunds, surrenders, redemptions, & maturities,”…“the rule of paragraph 2(A) shall not apply”6 (for which rule, and only for which rule, the “without regard to surrender charges” condition of Section 72(e)(3)(A) exists).