Let's assume that a 40-year-old client purchases a Single Payment Deferred Annuity (SPDA) for $50,000. Five years later, when the contract has grown to $75,000, the client wants to withdraw $35,000 for a vacation home. What are the tax ramifications?

$75,000     Annuity Value
- 50,000     Annuity Principal
$25,000     Annuity Earnings

$35,000     Withdrawal
- 25,000     Taxable Annuity Earnings
$10,000     Non-Taxable Return of Principal

Assuming the client is in a 28% tax bracket, he must pay income tax of $7,000 ($25,000 x 28%), plus a penalty tax of $2,500 ($25,000 x 10%), for a total tax liability of $9,500 on a $35,000 withdrawal. In addition, a contingent deferred sales charge will be assessed on the amount of the withdrawals in excess of 10% of the annuity value, or $7,500.

Death Prior to Annuitization

If annuity payments have not begun, the entire contract must be distributed within five years of the owner's death, or be annuitized over time not to exceed the new owner's life expectancy, as long as payments start within a year of the original owner's death. The new owner will be taxed upon surrender or annuitization as the original owner would have been taxed, except that if the annuity is surrendered, the distribution won't be subject to the 10% penalty tax. Contingent deferred sales charges apply upon the death of the owner, if the owner is not also the annuitant.

If the designated beneficiary is the annuity owner's spouse, the above distribution requirements do not apply. Instead, the spouse can become the new owner and tax deferral can continue. In either event, the value of the annuity will be included in the original owner's estate for estate tax purposes, but will avoid the delays and expense of probate, if paid to a named beneficiary.

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