If the annuitant surrenders the contract and receives a lump-sum distribution, any gain over the annuity principal is taxed as ordinary income in the year received. As demonstrated by the following example, this can substantially reduce the amount available to the annuitant to meet wealth accumulation or retirement income needs.
| $200,000 | Annuity Surrender Value | |
| - 40,000 | Annuity Principal | |
| $160,000 | Gain | |
| X .28 | Tax Bracket | |
| $ 44,800 | Income Tax Payable |
It is usually advantageous to annuitize the contract, spreading income tax payments over years.
The basic tax rule applied to annuity distributions is designed to return the annuitant's principal or investment in the contract in equal tax-free amounts over the payment period. Any additional amount is then taxed as ordinary income. This means that a portion of each annuity payment is received tax-free, while the balance is taxable. This serves to spread the annuitant's income tax liability over a period of years.
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