annuity). It should be noted this is the same tax treatment of direct participation in a qualified pension plan (such as a 401K), again, due to the fact the taxpayer has no tax basis in any of the money in the plan. If the annuity contract is purchased with after-tax dollars, then the contract holder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value, according to the tax regulation Section 1.72-5. (This is commonly referred to as the exclusion ratio.) After the taxpayer has recovered all of his basis, then 100% of the payments thereafter are subject to ordinary income tax. Since the Jobs and Growth Tax Relief Reconciliation Act of 2003, the use of variable annuities as a tax shelter has greatly diminished, because the growth of mutual funds and now most of the dividends of the fund are taxed at long term capital gains rates. This taxation, contrasted with the taxation of all the growth of variable annuities at income rates, means that in most cases, variable annuities shouldn't be used for tax shelters unless very long holding periods apply (for example, more than 20 years). Insurance company default risk and state guaranty associations An investor should consider the financial strength of the insurance company that writes annuity contracts. Major insolvencies have occurred at least 62 times since the conspicuous collapse of the Executive Life Insurance Company in 1991. Insurance company defaults are governed by state law. The laws are, however, broadly similar in most states. Annuity contracts are protected against insurance company insolvency up to a specific dollar limit, often $100,000, but as high as $500,000 in New York , New Jersey , and the state of Washington . California is the only state that has a limit less than 100%; the limit is 80% up to $300,000. This protection is not insurance and is not provided by a government agency. It is provided by an entity called the state guaranty association. When an insolvency occurs, the guaranty association steps in to protect annuity holders, and decides what to do on a case-by-case basis. Sometimes the contracts will be taken over and fulfilled by a solvent insurance company. The state guaranty association is not a government agency, but states usually require insurance companies to belong to it as a condition of being licensed to do business. The guaranty associations of