How Annuities Are Taxed: A Plain-English Guide

Annuity taxation is one of the most poorly explained topics in retirement planning. Insurance agents gloss over it. Personal finance articles oversimplify it. The IRS rules are clear but technical.

This guide walks through exactly how annuity withdrawals are taxed, with worked examples for the most common scenarios: lump-sum withdrawals, monthly annuitized payments, beneficiary inheritance, and 1035 exchanges.

The Core Principle: Tax Deferral, Not Tax Elimination

Annuities provide tax-deferred growth. While your money sits inside the contract, you don't pay annual taxes on dividends, interest, or capital gains the way you would in a brokerage account.

But you eventually pay. When earnings come out, they're taxed as ordinary income — not capital gains. This is critical: a long-term capital gain at 15% becomes ordinary income at 24% (or higher) when held inside an annuity. For high-growth investments, that's a meaningful penalty.

Qualified vs. Non-Qualified Annuities

Annuities are taxed differently based on where the money came from.

| Type | Source of Funds | What's Taxed on Withdrawal | |---|---|---| | Qualified Annuity | Pre-tax money (e.g., IRA rollover, 401(k) rollover) | Entire withdrawal is taxable | | Non-Qualified Annuity | After-tax money (e.g., brokerage account, savings) | Only the earnings portion is taxable |

A qualified annuity sits inside an IRA or 401(k). A non-qualified annuity sits outside any retirement account.

How Withdrawals Are Taxed

The IRS uses a "last-in, first-out" (LIFO) accounting rule for non-qualified annuities. This means earnings come out first when you take a withdrawal. Translation: your first dollars out are 100% taxable.

Example: Non-Qualified Annuity Withdrawal

Sarah has a non-qualified annuity she purchased for $200,000 ten years ago. The current value is $350,000. She withdraws $50,000 in a lump sum.

| Step | Calculation | Result | |---|---|---| | Original cost basis | After-tax money used to purchase | $200,000 | | Total earnings | $350,000 - $200,000 | $150,000 | | LIFO rule | Earnings come out first | $50,000 entirely taxable | | Tax (at 24% bracket) | $50,000 × 24% | $12,000 | | Net to Sarah | $50,000 - $12,000 | $38,000 |

Sarah's cost basis is preserved for future withdrawals. After this withdrawal, $100,000 of earnings remain taxable on future withdrawals before she gets to her tax-free principal.

If Sarah were under 59½, she'd owe an additional 10% IRS penalty on the $50,000 of earnings, costing another $5,000.

The Exclusion Ratio (Annuitized Payments)

When you fully annuitize a non-qualified annuity (convert it into a stream of payments), the LIFO rule no longer applies. Instead, you use the exclusion ratio, which spreads your principal recovery evenly across all payments.

Formula

Exclusion Ratio = Investment in Contract / Expected Return

The result is the percentage of each payment that is tax-free principal. The remainder is taxable as ordinary income.

Example: Exclusion Ratio in Action

David, age 65, buys a non-qualified single-life immediate annuity for $250,000. The insurer agrees to pay him $1,500/month for life. Per IRS Table V, his life expectancy is 20 years.

| Step | Calculation | Result | |---|---|---| | Investment in contract | Purchase price | $250,000 | | Expected return | $1,500 × 12 × 20 years | $360,000 | | Exclusion ratio | $250,000 / $360,000 | 69.4% | | Tax-free portion of each payment | $1,500 × 69.4% | $1,041 | | Taxable portion of each payment | $1,500 × 30.6% | $459 |

For each $1,500 monthly payment, $1,041 is tax-free recovery of principal and $459 is taxable income.

This continues until David has fully recovered his $250,000 cost basis. After that, 100% of each payment becomes taxable. If David lives beyond his 20-year life expectancy, payments after that are fully taxable.

If David dies before recovering his full basis, his unrecovered basis is deductible on his final tax return.

The 10% Early Withdrawal Penalty

Withdrawals from any annuity (qualified or non-qualified) before age 59½ are generally subject to a 10% IRS penalty on the taxable portion. Exceptions:

• Death of the owner
• Total disability
• Substantially Equal Periodic Payments (Section 72(q) for non-qualified, 72(t) for qualified)
• Annuitization with payments expected over life expectancy

Note: this is separate from any surrender charges the insurance company assesses. See our annuity surrender charges guide for those rules.

1035 Exchanges

Section 1035 of the Internal Revenue Code allows you to exchange one annuity for another (or transfer cash value from a life insurance policy into an annuity) without triggering a taxable event.

This is enormously useful. If you're stuck in a high-fee variable annuity, a 1035 exchange to a low-cost fixed annuity preserves your cost basis and tax deferral.

| 1035 Exchange Rule | Detail | |---|---| | Same owner required | Annuities must be owned by same person before and after | | Same annuitant required | Same person whose life is insured | | Like-kind only | Annuity to annuity, life insurance to annuity (one-way) | | Direct trustee-to-trustee transfer | Cannot take possession of funds | | Surrender charges still apply | The insurer can still assess surrender charges on the original contract |

A common use case: someone bought a complex variable annuity in their 50s, regrets it in their 60s, and 1035s the funds into a simpler MYGA. The cost basis carries over. The tax deferral continues. No taxable event occurs.

Inherited Annuities

Annuity inheritance rules changed dramatically with the SECURE Act (effective 2020). For most non-spouse beneficiaries:

| Beneficiary Type | Distribution Rule | |---|---| | Surviving spouse | Can continue contract as own; multiple options including spousal continuation | | Eligible designated beneficiary | (Disabled, chronically ill, or under 10 years younger than owner) — can stretch payments over life expectancy | | Other designated beneficiaries | Must withdraw all funds within 10 years (the "10-year rule") | | Estate or non-designated | Must withdraw within 5 years |

Within the 10-year window, beneficiaries can take withdrawals at any pace. All earnings remain ordinary income; cost basis is recovered tax-free using LIFO rules.

Roth Conversions and Annuities

You cannot directly Roth-convert money inside a non-qualified annuity. Roth conversions only work with qualified retirement money (IRA, 401(k), 403(b)).

However, if you have a qualified annuity inside an IRA, you can do a Roth IRA conversion on it. The taxable portion of the conversion is treated as ordinary income in the year of conversion. This can be beneficial if:

• You're in a temporarily lower tax bracket (early retirement, low-income year)
• You want tax-free withdrawals later
• You want to avoid required minimum distributions

A properly executed Roth conversion of a qualified annuity is a sophisticated strategy. Consult both a tax professional and a financial planner before attempting it.

State Tax Considerations

Annuity income is subject to state income tax in most states. Notable exceptions:

| State | Annuity Income Tax Treatment | |---|---| | Florida | No state income tax — annuity income is not state-taxed | | Texas | No state income tax | | Tennessee | No state income tax | | Wyoming | No state income tax | | Pennsylvania | Annuity income generally exempt from state tax | | Illinois | Most retirement income (including annuities) exempt from state tax |

If you're considering a relocation in retirement, the state tax treatment of your annuity income can meaningfully change your net retirement budget.

A Comprehensive Worked Example

Margaret, 67, retires. Over her career she accumulated:

• $400,000 in a Traditional IRA (qualified)
• $200,000 in a non-qualified annuity she bought 15 years ago (cost basis $100,000, current value $200,000)

She decides to:

1. Roll the IRA into a qualified MYGA (no tax event — IRA-to-IRA rollover)
2. Annuitize the non-qualified annuity into monthly income

Tax treatment:

For the qualified annuity, every dollar withdrawn is taxable as ordinary income.

For the non-qualified annuity, IRS Table V shows life expectancy at age 67 of 18.4 years.

• Investment in contract: $100,000
• Expected return: $1,200/month × 12 × 18.4 = $264,960
• Exclusion ratio: $100,000 / $264,960 = 37.7%
• Tax-free per payment: $1,200 × 37.7% = $452
• Taxable per payment: $1,200 × 62.3% = $748

Margaret's total monthly retirement income from these two annuities: combined gross of $3,200/month, with $452 tax-free and the rest taxable as ordinary income.

For more on income strategies, see our annuity vs 401(k) and annuity payout by age guides.

Frequently Asked Questions

Are annuity withdrawals taxed as ordinary income or capital gains? Earnings are taxed as ordinary income, not capital gains. This is true regardless of how long you held the annuity.

Do I pay taxes on the principal of a non-qualified annuity? No. The principal you put in (cost basis) was after-tax money. Only the earnings are taxed when withdrawn.

Can I avoid taxes by gifting an annuity? No. Gifting an annuity triggers immediate taxation of any gain at the moment of transfer (and may also have gift-tax implications).

What's the 10% IRS penalty on annuities? A 10% penalty on the taxable portion of withdrawals taken before age 59½, with limited exceptions.

Can I do a 1035 exchange from a variable annuity to a fixed annuity? Yes. This is one of the most common 1035 exchange uses — escaping high-fee variable annuities into low-cost fixed alternatives without triggering tax.

How does the SECURE Act affect annuity inheritance? Most non-spouse beneficiaries must now withdraw all inherited annuity funds within 10 years. Spouses have more flexibility, including spousal continuation.

This article is for educational purposes only and does not constitute financial, tax, or legal advice. Annuity taxation is complex and depends on your specific situation. Consult a licensed financial advisor or tax professional before making any retirement planning decisions.