How Annuities Are Taxed: Annuity Tax Rules Explained

How annuities are taxed depends on two things: whether the annuity is funded with pre-tax retirement money or after-tax money, and whether you take a withdrawal or turn the contract into a stream of income payments. Annuities grow tax-deferred, so you pay taxes only when money comes out, and the taxable part is taxed as ordinary income.

That is the short answer. The detail below follows the annuity tax rules in IRS Publication 575, Pension and Annuity Income, IRS Publication 939, General Rule for Pensions and Annuities, and IRS Topic No. 410. This page explains the rules. It does not tell anyone what to do with their own return, and it is not tax or legal advice.

The two questions that decide how annuities are taxed

Every annuity tax question starts in the same place. How the money went in, and how the money comes out.

How was the annuity funded? Qualified annuities are funded with pre-tax dollars inside a retirement plan or IRA. Nonqualified annuities are funded with after-tax money that has already been through the income tax system.
How is money coming out? Annuity withdrawals from a deferred contract are taxed one way. Annuitized annuity payments, spread over a fixed period or over a lifetime, are taxed another way.

One rule applies to both. Annuities grow tax-deferred. The U.S. Securities and Exchange Commission states the point plainly on Investor.gov: you pay no taxes on interest or investment gains inside the annuity contract until you withdraw the money, receive income payments, or a death benefit is paid.

Tax deferral is the main tax benefit, and it has a limit

Deferral is the tax advantage that annuity products are built around. Interest and gains inside deferred annuities are not reported year by year, so nothing is taxed until a distribution happens. Fixed, indexed and variable annuities all share that treatment. Purchasing an annuity does not create a deduction, though; premiums paid to fund an annuity outside a retirement plan are paid with money that has already been taxed.

The limit is just as important. Deferral postpones income tax. It does not cancel it. The money in an annuity is not taxed while it sits there, and then it is. Whether that trade helps a particular retirement income plan is a question for a tax professional, not a general rule.

Qualified annuities: the whole annuity payment is usually taxable

Qualified annuities sit inside a traditional IRA, a 401(k), a 403(b), or a similar retirement plan. The contributions were never taxed and the earnings were never taxed, so when you take money out of an annuity like this you generally owe ordinary income tax on the full amount.

IRS Topic No. 410 puts it this way: pension or annuity payments are fully taxable if the recipient has no investment in the contract. “Investment in the contract” is the IRS term for after-tax money already paid in. In a standard pre-tax retirement account that figure is zero, so nothing comes back tax free and the payout will be taxed in full.

There is an exception inside the qualified category. If after-tax dollars were contributed to the plan, the payments are partly taxable, and the part representing a return of those after-tax amounts is not taxed again. Roth accounts follow separate rules. A tax professional can confirm which of these applies to a specific plan.

Nonqualified annuities: only the earnings are taxed

Nonqualified annuities are funded with after-tax premium. That premium is not taxed a second time. Only the growth is. But how the earnings are taxed changes depending on how funds from an annuity are taken.

Annuity withdrawals: gains come out first

Take a partial withdrawal from a nonqualified deferred annuity and the IRS does not treat it as a proportional slice of principal and growth. Publication 575 states that for contracts purchased after August 13, 1982, the amount withdrawn is allocated first to earnings, which is the taxable part, and then to cost, which is the tax-free part.

Practitioners call this last-in, first-out treatment, or LIFO. In practice, withdrawals from an annuity that has grown are fully taxable as ordinary income until all the gain has been distributed. Only after the gain is exhausted do withdrawals reach the original after-tax premium and stop being taxable. So the tax on the earnings portion is paid first, and the return of principal comes last. Surrender charges set by the contract are a separate matter from tax, and the SEC notes on Investor.gov that withdrawing money from an annuity within a certain number of years of purchase may trigger one.

How annuitized payments are taxed: the exclusion ratio

Convert a nonqualified contract into a stream of income payments and a different rule applies. Each annuity payment is taxable only in part. It is split into a tax-free return of the investment in the contract and a taxable portion that represents earnings and is taxed as ordinary income. The split is set by the exclusion ratio.

IRS Publication 939 describes the General Rule as the method for figuring the tax-free part of each annuity payment “based on the ratio of your investment in the contract to the total expected return.” Investment in the contract goes on top. Total expected return, meaning the total of the payments the contract is expected to produce, goes on the bottom. The resulting fraction is the share of every payment that is excluded from income.

Two consequences follow, and both surprise people.

The exclusion is capped at the actual cost. Publication 575 states that the total amount excluded over the years as a recovery of cost cannot exceed total cost. The tax-free amount is figured when the annuity starts and stays the same each year.
Once the basis is recovered, the payments are fully taxed as ordinary income. A lifetime annuity that pays for longer than expected will eventually return the entire investment in the contract. From that point on, every dollar of every payment is ordinary income.

The reverse case also has a rule. If the annuitant dies before recovering the full investment, Publication 575 provides that any unrecovered cost is allowed as an itemized deduction on the decedent’s final return.

Are annuities taxed as income or capital gains?

As income. This is the point most often misunderstood. Gains inside an annuity do not get long-term capital gains treatment, no matter how long the annuity contract was held and no matter what the underlying investments did. Publication 575 states that the taxable part of a distribution is treated as ordinary income.

So the taxable portion is added to other income and you owe ordinary income tax at your marginal federal rate for that year. There is no preferential rate, and the qualified dividend and long-term gain rates do not apply. Where a taxable brokerage account can produce capital gains, deferred annuities convert that growth into ordinary income when it is distributed.

Early withdrawal from an annuity before age 59½

Money taken out of an annuity before age 59½ may carry tax penalties on top of regular income tax. IRS Topic No. 558 states that the additional tax equals 10% of the portion of the distribution that is includible in gross income, and that early distributions are those received from a qualified retirement plan or deferred annuity contract before reaching age 59½.

Note the base. The early withdrawal penalty applies to the taxable part, not to a return of after-tax premium. Note also that this federal tax is separate from any surrender charge the insurer applies under the contract.

The IRS lists a long set of exceptions. Among those named in Topic No. 558 and Publication 575:

Distributions made as part of a series of substantially equal periodic payments over life expectancy
Distributions made because the recipient is totally and permanently disabled
Distributions to a terminally ill individual, certified as required
Distributions made on or after the death of the plan participant or contract owner
Distributions for unreimbursed medical expenses above 7.5% of adjusted gross income
Distributions made under an IRS levy
Qualified birth or adoption distributions
Qualified reservist distributions, and distributions to victims of domestic abuse or for certain emergency personal expenses

Not every exception reaches every contract. Several are written for employer retirement plans rather than for nonqualified annuities. The current list, and whether a distribution qualifies, should be confirmed with a tax professional or read directly in IRS Topic No. 558.

Required minimum distributions on qualified deferred annuities

An annuity held inside a traditional IRA or an employer retirement plan is subject to the required minimum distribution rules that apply to that account. The IRS states that withdrawals from a traditional IRA, SEP IRA, SIMPLE IRA, and retirement plan accounts generally must start at age 73, with the first distribution due by April 1 of the following year. Those payments are taxed as ordinary income when they are taken.

The IRS also states that the RMD rules do not apply to Roth IRAs or designated Roth accounts while the owner is alive, though they do apply to beneficiaries. Nonqualified annuities are not IRA assets and are not subject to the IRA required minimum distribution schedule; their payout timing is governed by the annuity contract and by the distribution rules in the tax code.

Exchanging one annuity contract for another

Publication 575 includes a section on transfers of annuity contracts and describes exchanges that are not taxable at the time of the exchange. Under Internal Revenue Code section 1035, an annuity contract can be exchanged for another annuity contract without triggering income tax on the gain, with the cost basis carrying over to the new contract. The transaction is still reported, and Publication 575 notes that a tax-free exchange may be reported on Form 1099-R.

These tax rules are specific and easy to fail on a technicality. Anyone considering an exchange should speak with a tax professional before it is executed.

How inherited annuities are taxed

Death does not erase the deferred gain. There is no basis step-up that wipes out the untaxed earnings in an annuity. Publication 575 states that a single-sum distribution from a variable annuity contract received because of the death of the owner or annuitant is generally taxable to the extent it is more than the unrecovered cost of the contract. IRS Publication 559 treats pension and annuity amounts a beneficiary receives as income in respect of a decedent, which keeps the ordinary income character intact.

What varies is timing. Payout options available to a beneficiary, and the deadlines attached to them, depend on the contract terms, the beneficiary’s relationship to the owner, and whether the annuity is qualified or nonqualified. These are the specifics a tax professional should price out before a beneficiary elects a payout.

State income taxes on annuity income

Federal rules are only part of the picture. State income taxes are set state by state, and some states tax retirement income that others exempt.

Florida does not tax it, because Florida does not tax personal income at all. The Florida Department of Revenue states in its Tax Information for New Residents brochure that Florida does not impose personal income tax, inheritance tax, gift taxes, or tax on intangible personal property. For a Florida resident, the taxable portion of an annuity payment is subject to federal income tax and no state income tax.

Residency is what controls, and residency can change. Someone who receives annuity income while living in another state is subject to that state’s rules.

Reporting and withholding

Distributions from annuities and retirement plans are reported to the recipient and to the IRS on Form 1099-R. IRS Topic No. 410 states that the taxable part of pension or annuity payments is generally subject to federal income tax withholding, that Form W-4P is used to elect no withholding or to specify an amount, and that a payer who receives no Form W-4P must withhold as though the filing status is single with no adjustments.

Withholding is not the same as the tax owed. It is a prepayment. The actual liability is settled on the return.

Frequently asked questions about annuity taxation

How much tax do you pay on annuity income?

There is no separate annuity tax rate. The taxable portion is ordinary income, so it is taxed at the recipient’s marginal federal income tax rate for the year, on top of wages, taxable Social Security, and other income. How much of a given annuity payment is taxable depends on whether the contract is qualified or nonqualified and on whether the money is a withdrawal or an annuitized payment.

Are annuities taxable if you never take money out?

No. Growth inside the contract is not taxed while it stays there. The deferral ends when you withdraw money from your annuity, when income payments begin, or when a death benefit is paid.

How can you avoid or minimize taxes on annuities?

Tax on the earnings in deferred annuities is postponed, not canceled. Some transactions, such as a section 1035 exchange between annuity contracts, are structured so that no tax is due at the moment of the transaction while the basis and the deferred gain carry over. Timing distributions, and the choice between funding an annuity with pre-tax or after-tax money, also change the result. Any strategy aimed at reducing annuity tax should be reviewed with a qualified tax professional against the individual’s own return.

Can I deduct annuity premiums?

Premiums paid into a nonqualified annuity are not deductible; they are paid with after-tax dollars, which is why they come back tax free later. Contributions to a qualified annuity inside a retirement plan or IRA follow that plan’s own deduction rules, not annuity rules.

Are taxes automatically taken out of annuity payments?

Federal income tax is generally withheld from the taxable part of the payment unless the recipient elects otherwise on Form W-4P, per IRS Topic No. 410. The amount withheld may be more or less than the tax actually owed.

Do you have to report annuity payments on your tax return?

Yes. Distributions are reported on Form 1099-R and the taxable amount is reported on the recipient’s federal income tax return, even when part of the annuity payment is a tax-free return of cost.

Are annuity death benefits taxable to a beneficiary?

The untaxed gain remains subject to income taxes when the beneficiary receives it, as ordinary income. Available payout options and their deadlines depend on the contract and on the beneficiary’s status. A tax professional should review the election before it is made, because it is generally irrevocable.

Annuity payments are not earned income for the Social Security earnings test. The taxable portion is still income on the federal return, and it can affect how much of a Social Security benefit is taxable. That interaction is specific to each return and belongs with a tax professional.

Where to read the annuity tax rules directly

The primary sources on the taxation of annuities are IRS Publication 575, Pension and Annuity Income, IRS Publication 939, General Rule for Pensions and Annuities, IRS Topic No. 410, Pensions and Annuities, and IRS Topic No. 558 on the additional tax on early distributions. The SEC’s investor education material on annuities is at Investor.gov.

Disclosures

This article is general information about federal tax rules as published by the IRS. It is not tax advice, legal advice, or a recommendation. Tax treatment depends on individual circumstances, including the type of annuity, the source of the funds, the age of the owner, the terms of the annuity contract, and the taxpayer’s own return; anyone weighing an annuity transaction should consult a qualified tax professional before acting. Tax rules and IRS guidance change. Annuities are insurance products; guarantees, including any guaranteed income, rest on the claims-paying ability of the issuing insurer and are not FDIC insured or bank guaranteed. Lifeworth Insurance Agency is a trade name of Lifeworth Financial Group LLC, National Producer Number 21228343, licensed in Florida.