Annuities LIFO or FIFO? | rules of engagement

Oct 9

3 min read

One of the biggest mistakes investors make is treating all annuities the same. A fixed annuity, MYGA, fixed indexed annuity, SPIA, or hybrid long-term care annuity may all carry the same label, but they serve different purposes and often produce different tax outcomes. Is the better question, “How are annuities taxed?”

Here's another, "What type of annuity do I own now, how was it funded, and how will the money come out?"

First Question: Qualified or Non-Qualified?

The tax treatment starts with the source of the money.

Qualified annuities are funded with pre-tax retirement dollars, such as IRA or 401(k) assets. Withdrawals are generally taxable as ordinary income.
Non-qualified annuities are funded with after-tax money. Your original investment (basis) has already been taxed, but growth remains tax-deferred until withdrawn.

For most annuity owners, the LIFO versus FIFO discussion applies primarily to non-qualified deferred annuities.

Understanding LIFO: The Rule That Surprises Many Owners

Most non-qualified deferred annuities are taxed using Last-In, First-Out (LIFO) rules.

Under LIFO, your gains are considered to come out first and are taxed as ordinary income before you can access your tax-free principal.

Example:

Original investment: $100,000
Current value: $140,000
Gain: $40,000

If you withdraw $25,000, that entire withdrawal may be taxable because it is treated as coming from the gain first.

Many retirees are surprised to learn this. They know they already paid taxes on the money used to purchase the annuity, yet the IRS generally requires taxable growth to come out before basis.

What About FIFO?

First-In, First-Out (FIFO) would allow your original principal to come out first, making early withdrawals largely tax-free until basis is exhausted.

While that sounds attractive, FIFO is not the standard tax treatment for most non-qualified deferred annuities.

This misunderstanding often occurs because investors assume annuities work like bank accounts, CDs, or brokerage accounts. They don't.

With most deferred annuities, the default assumption should be LIFO unless the contract structure dictates otherwise.

Why SPIAs Are Different

A Single Premium Immediate Annuity (SPIA) can create a different tax experience.

When funded with non-qualified money, each payment typically includes:

A taxable portion
A tax-free return of principal

This treatment, commonly called an exclusion ratio, spreads basis recovery throughout the income stream instead of forcing all gains out first.

For retirees seeking predictable income, that distinction can significantly improve after-tax cash flow.

The Real Tax Planning Question

Tax deferral is valuable, but tax deferral is not tax elimination.

Annuities can be excellent tools for:

Protected growth
Guaranteed income
Long-term care planning
Legacy strategies

However, the taxation depends just as much on the withdrawal strategy as the product itself.

Before taking money from any annuity, know:

Whether it is qualified or non-qualified
Your cost basis
The amount of gain in the contract
Any surrender charges
Available income options
Whether a 1035 exchange should be considered

The difference between a smart withdrawal and an expensive tax surprise often comes down to understanding these details first.

Three Action Steps Before You Withdraw

1. Determine Your Tax Classification

Know whether your annuity is qualified or non-qualified. This single distinction drives much of the tax outcome.

2. Calculate Basis and Gain

Request a current contract statement showing cost basis, account value, and taxable gain before making any withdrawal decision.

3. Review Your Annuity's Purpose

Is the contract intended for income, legacy planning, liquidity, or long-term care protection? The right tax strategy depends on the job the annuity is expected to perform.

Bottom Line: Stop asking whether annuities are good or bad for taxes. Start asking what type of annuity you own, how it is funded, and what happens when money comes out. The tax answer is almost always found in the details.

MORE INFO: joesimon.solutions

CONTACT JOE: js@joesimon.solutions

This article is for educational purposes only and should not be considered tax, legal, or investment advice. Consult a qualified tax professional regarding your specific situation before making financial decisions.