Distributions from nonqualified annuities are generally subject to income tax. The tax treatment of these distributions depends on several factors, including the amount of the distribution, the owner's age, and the annuity's cost basis. Here are some key points to consider:
1. Taxable Portion: The taxable portion of a distribution from a nonqualified annuity is generally determined by the annuity's exclusion ratio. The exclusion ratio is calculated by dividing the annuity's cost basis by its expected return. The cost basis is the total amount of after-tax contributions made to the annuity, while the expected return is the total amount of anticipated tax-free return.
2. Ordinary Income Tax: The taxable portion of a distribution is generally subject to ordinary income tax rates. This means that the distribution is taxed at the individual's marginal tax rate.
3. Early Withdrawal Penalty: If the annuity owner is under the age of 59½ at the time of the distribution, an additional 10% early withdrawal penalty may apply to the taxable portion of the distribution. However, there are certain exceptions to this penalty, such as for disability or death.
4. Partial Exchanges: If the annuity owner exchanges a portion of their nonqualified annuity for another annuity, the tax treatment of the exchange depends on whether it qualifies as a tax-free exchange under Section 1035 of the Internal Revenue Code. If the exchange meets the requirements, it is generally not taxable.
5. State Taxes: In addition to federal income tax, distributions from nonqualified annuities may also be subject to state income tax. The specific tax treatment varies by state, so it's important to consult with a tax professional or refer to your state's tax laws.
It's worth noting that the tax rules surrounding annuities can be complex, and individual circumstances may vary. It's always a good idea to consult with a qualified tax professional or financial advisor for personalized advice regarding your specific situation.