Texas Life & Health: Federal Tax Considerations — Life & Annuities

Correct

The answer is A: The exclusion ratio splits each payment into basis and taxable earnings.

For non-qualified annuities, a portion of each payment received is considered a return of the original principal (cost basis) and is tax-free, while the remainder is considered earnings and is taxable as ordinary income. This is determined by the exclusion ratio, which calculates the percentage of each payment that represents a return of the investment. The exclusion ratio is calculated as (Investment in the contract / Expected return). In this case, $150,000 / $180,000 = 83.33% of each payment is tax-free, and 16.67% is taxable. Taxing the entire payment ignores her $150,000 basis. Taxing only payments made after the $150,000 is recovered describes a 'cost recovery' method, which is not how non-qualified annuities are typically taxed on a periodic basis. Payments are not entirely tax-free, because earnings from non-qualified annuities are taxable.

Reviewed in our October 2026 Texas fact-check.

Correct

The answer is D: $25,000 taxed as ordinary income (LIFO), plus a 10% penalty.

Pre-annuitization withdrawals from a non-qualified deferred annuity are LIFO — earnings come out first. The $40,000 of gain is taxed before any basis. Because Brett took $25,000 and the gain ($40,000) is larger, the entire $25,000 is taxable as ordinary income. Since Brett is under 59½ with no exception, a 10% additional tax applies to the taxable portion.

Reviewed in our October 2026 Texas fact-check.

Correct

The answer is C: $9,000 — 10% of the withdrawal is tax-free basis.

Under IRC § 72, when an IRA contains both pre-tax and after-tax money, distributions recover basis pro-rata across ALL Traditional IRAs of the taxpayer. Basis ratio = $5,000 ÷ $50,000 = 10%. Of the $10,000 distribution, $1,000 is tax-free recovery of basis and $9,000 is taxable as ordinary income.

Reviewed in our October 2026 Texas fact-check.

Correct

The answer is C: Includible but offset by the marital deduction, so no tax is due.

If Brian held incidents of ownership in the policy on his life, the $800,000 is includible in his gross estate under IRC § 2042 (only half of it, if the policy was community property). However, because Sandra (a U.S. citizen spouse) is the beneficiary, the proceeds qualify for the unlimited marital deduction under IRC § 2056, eliminating federal estate tax on this transfer. (The proceeds will eventually be in Sandra's estate when she dies, unless spent or transferred.)

Reviewed in our October 2026 Texas fact-check.

Correct

The answer is D: No gain recognized; the $40,000 basis carries over.

IRC Section 1035 permits tax-free exchanges between like contracts: annuity-to-annuity is one of the permitted directions. Brian's $40,000 basis carries over to the new contract, and the $60,000 of accumulated gain remains tax-deferred until eventually distributed. Recognizing $60,000 now taxes gain unnecessarily. Taxing the full $100,000 ignores basis recovery. Annuity-to-annuity is explicitly permitted (alongside life-to-life and life-to-annuity; only annuity-to-life is prohibited).

Reviewed in our October 2026 Texas fact-check.