NQ annuity distributions from more recent contracts are considered allocated to earnings on the contract until the earnings are distributed. Then they become return of principal. Therefore, as long as the distributions are more than covered by earnings, they will continue to be taxable at ordinary income rates. Once client dips into principal, the distributions will be tax free. They have been withdrawing slightly less than the earnings each year, so if that continues, so does the taxable income.

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Doug,
The fact that prior year 1099R forms indicate distributions as taxable means that the distributions are “non periodic”. A non periodic distribution always comes first from income. In this case the earnings and the distribution amounts per year are close, close enough so that any surrender or other fees would place the value below the invested amount, particularly if the annual earnings are not posted until year end whereas the distributions are taken prior to crediting the earnings.

Pub 575 indicates that the amount of earnings in the contract should be determined at the time of each distribution. If a distribution is taken at a time when the cash value is less than 100,000, then it should be tax free, if taken when the cash value is slightly over 100,000 based on earnings postings, then the distribution could be partially or fully taxable. If surrender or other charges have pushed the cash value permanently below 100,000, then distributions may be tax free as return of principal.

I recommend securing the tax accounting details directly from the insurance company, particularly in a case like this where the earnings are nearly withdrawn every year and the timing of distributions and earnings as well as fees enter the picture.

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