What Is the Cost Basis of an Annuity? Withdrawals, 1035s, Inheritance

The cost basis of an annuity is the total after-tax money you have paid into the contract, reduced by any amounts you have already received back tax-free. The Internal Revenue Code calls this your “investment in the contract,” and it is the figure that decides how much of every future dollar comes out taxable and how much comes out tax-free.¹ Anything you receive above that number is treated as earnings and taxed as ordinary income.

Your basis does not move with the market. The contract’s value rises and falls with credited interest or investment performance, but the basis is a running ledger of what you have put in minus what you have already gotten back without tax.

What Goes Into Your Basis, and What Comes Out

Under Treasury regulations, you start with every premium or other payment made into the contract and then subtract amounts that have already come out of you tax-free.²

Adds to basis:

Every initial and subsequent premium you paid with after-tax money, dollar for dollar.

Subtracts from basis:

Prior distributions that were excluded from your income. If you put in $100,000 and have already taken $5,000 tax-free, your adjusted basis is $95,000.
Unrepaid policy loans and dividends applied against loan principal or interest.²
Charges deducted from cash value to pay for a qualified long-term care rider.¹

Not every fee the insurer takes affects your basis. Mortality and expense charges, administrative fees, and investment management fees that come out of the account value are contract operating costs. Only charges the tax code specifically treats as a return of investment reduce basis.

How Basis Works When You Take a Withdrawal

For a non-qualified deferred annuity that has not been annuitized, the IRS applies an earnings-first rule. Every dollar you pull out is taxable as ordinary income until you have withdrawn all the gain in the contract. Only after the gain is exhausted do additional withdrawals come from your tax-free basis.³

A concrete example. You paid $100,000 into a deferred annuity that has grown to $120,000. You take out $15,000. The contract holds $20,000 of gain, so the entire $15,000 is taxable and your basis stays at $100,000. If instead you took $25,000, the first $20,000 would be fully taxable (the full gain), and only the remaining $5,000 would be a tax-free return of basis, dropping your investment in the contract to $95,000.

The statute puts it this way: a pre-annuitization withdrawal is included in income to the extent it is allocable to income on the contract and excluded to the extent it is allocable to your investment, with earnings treated as coming out first.¹

Contracts Bought Before August 14, 1982

Older contracts get the opposite treatment. Withdrawals come from basis first and are only taxable once the entire investment has been recovered.¹ This favorable rule applies only to the investment and earnings tied to the pre-August 14, 1982 period. Money added on or after that date follows the earnings-first rule.³

The 10% Penalty Before 59½

If you are under 59½, the taxable portion of a withdrawal is also hit with an additional 10% tax under Section 72(q).¹ Exceptions include distributions after the owner’s death, distributions due to disability, substantially equal periodic payments over your life expectancy, and payments from an immediate annuity contract.⁴ The 10% applies only to the taxable portion, never to a return of basis.

How Basis Works When You Annuitize

Once you convert the contract into a stream of regular payments, the earnings-first rule is replaced by an exclusion ratio. Each payment is split into a taxable piece and a tax-free piece. The formula is your investment in the contract divided by the total expected return under the contract.¹

Expected return depends on the payout. For a fixed-period annuity it is the annual payment multiplied by the number of years. For a life annuity, the IRS uses actuarial tables tied to your life expectancy at the annuity starting date.³

If your investment in the contract is $100,000 and the expected return is $200,000, the exclusion ratio is 50%. Fifty cents of every dollar is a tax-free return of basis; the other fifty cents is ordinary income. The ratio is set at the starting date and does not change.

Two limits apply depending on when payments began:

If your annuity starting date is after 1986, once you have excluded a total equal to your investment in the contract, every later payment is fully taxable. You cannot exclude more than your basis.³
If your starting date is before 1987, the exclusion continues for as long as payments continue, even if the total excluded eventually exceeds your cost.³

If the Annuitant Dies With Basis Left

If payments stop because the annuitant dies before recovering the full investment in the contract, the unrecovered amount is allowed as a deduction on the annuitant’s final return.⁵ It is an itemized deduction that is not subject to a floor or to suspension.³

Qualified Annuities Usually Have Zero Basis

An annuity held inside a Traditional IRA, 401(k), or similar tax-deferred account is a qualified annuity. Because contributions typically went in pre-tax, your investment in the contract is generally zero and every dollar distributed is fully taxable as ordinary income.⁶

The exception is non-deductible contributions to a Traditional IRA. Those create basis, and you track them on Form 8606. Failing to file the form when required carries a $50 penalty per year.⁷

When basis exists inside a Traditional IRA, distributions come out under a pro-rata rule. You cannot cherry-pick the non-deductible portion. Each distribution is split between taxable and tax-free amounts based on the ratio of your total basis to the combined value of all your Traditional IRAs, not just the one holding the annuity.

Basis Follows You Through a 1035 Exchange

Section 1035 lets you swap one annuity contract for another without triggering tax, and the same provision covers exchanges of annuities for qualified long-term care insurance.⁸ Your investment in the contract carries over. If the old contract had $100,000 of basis, the new contract starts with $100,000 of basis regardless of the cash value transferred.

In a partial 1035 exchange, the IRS requires you to allocate basis ratably between the original and the new contract based on the percentage of cash value moved.⁹ Move 40% of the cash value and 40% of the basis goes with it; 60% stays behind.

Inherited Annuities Do Not Get a Step-Up

Annuities are excluded from the step-up in basis rule that resets most inherited assets to their date-of-death value. Section 1014 does not apply to them.¹⁰ The beneficiary inherits the original owner’s basis, and the built-in gain is treated as income in respect of a decedent under Section 691, taxed as ordinary income to the beneficiary when distributions are taken.¹¹

A surviving spouse can continue the contract in their own name and keep deferring tax until they take distributions. Non-spouse beneficiaries generally choose between a lump sum or spreading distributions over a period not exceeding five years from the owner’s death, depending on contract terms. In either case, the original basis carries forward and offsets part of each distribution.

Multiple Contracts From the Same Insurer in the Same Year

If you buy more than one annuity contract from the same insurance company in the same calendar year, the IRS treats them as a single contract for figuring the taxable portion of a withdrawal.¹ Gains and basis are pooled, so you cannot isolate basis in one contract and pull from it to avoid tax. Contracts from different insurers, or from the same insurer in different calendar years, are not aggregated.

Keep Your Own Records

Tracking basis is your job. The insurer will send a Form 1099-R with a taxable amount in Box 2a, but that number depends on what the insurer has on file. If their records are incomplete, the taxable amount they report can be too high, and the burden of proving otherwise falls on you.

Hold on to every premium payment confirmation, annual contract statement, and 1099-R. If you have done a 1035 exchange, keep the basis documentation from the original contract, because that history is what the new contract inherits. For qualified annuities with non-deductible contributions, each year’s Form 8606 is part of that chain.⁷ Without the records, the IRS can treat a distribution as fully taxable and leave you to prove the basis you actually have.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
eCFR. 26 CFR 1.72-6 – Investment in the Contract
3
Internal Revenue Service. Publication 575 – Pension and Annuity Income
4
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
5
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
6
Internal Revenue Service. Topic No. 410, Pensions and Annuities
7
Internal Revenue Service. Instructions for Form 8606
8
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Revenue Procedure 2011-38
10
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
11
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents