How Are Annuities Taxed? IRS Rules You Need to Know

Annuities offer powerful tax-deferred growth, but the tax rules governing them are more complex than those for most retirement accounts. How your annuity is taxed depends on whether it is qualified or non-qualified, how you take your money out, when you take it out, and who receives the money if you pass away. Getting these details right can save you thousands of dollars in taxes over your lifetime. Getting them wrong can result in unexpected tax bills and penalties.

This guide breaks down the IRS rules for annuity taxation in clear, practical terms. We cover tax-deferred growth, how withdrawals and annuity payments are taxed, the early withdrawal penalty, 1035 exchanges, inherited annuity rules, and required minimum distributions. Consult a tax professional for advice specific to your situation, as individual circumstances can significantly affect your tax outcome.

Tax-Deferred Growth: The Core Benefit

The primary tax advantage of an annuity is tax-deferred growth. When your money is inside an annuity, you do not pay taxes on interest, dividends, or investment gains as they accumulate. This allows your money to compound faster than it would in a taxable account, where taxes reduce your balance each year.

For example, if you invest $100,000 in an annuity earning 5 percent annually, your entire $5,000 in earnings stays invested and continues to grow. In a taxable account, you might owe taxes on those earnings each year, reducing the amount available to compound. Over 20 or 30 years, this tax deferral can result in significantly more accumulated wealth.

Tax deferral does not mean tax avoidance. You will eventually owe taxes on the earnings when you withdraw them. The benefit is timing: you delay paying taxes until retirement, when many people are in a lower tax bracket. Additionally, by deferring taxes, you keep more of your money working for you during the accumulation years.

Qualified vs. Non-Qualified Annuity Tax Treatment

The most fundamental distinction in annuity taxation is whether the annuity is qualified or non-qualified. This single factor determines how contributions and withdrawals are taxed.

Qualified annuities are purchased with pre-tax dollars inside a tax-advantaged retirement account such as a traditional IRA, 401(k), or 403(b). Because contributions were never taxed, every dollar you withdraw is taxed as ordinary income. There is no distinction between contributions and earnings. The entire withdrawal is taxable. Qualified annuities are subject to the same RMD rules as the retirement account that holds them.

Non-qualified annuities are purchased with after-tax dollars outside of a retirement account. Because you already paid income taxes on the money you used to buy the annuity, only the earnings portion of your withdrawals is taxable. Your original premium (your cost basis) comes back to you tax-free. Non-qualified annuities do not have required minimum distributions, giving you more control over when and how you take your money.

How Withdrawals Are Taxed: The LIFO Rule

When you take a partial withdrawal or surrender from a non-qualified annuity, the IRS uses last-in, first-out (LIFO) ordering. This means your earnings are considered to be withdrawn first. Since earnings are the taxable portion, your initial withdrawals are fully taxable as ordinary income until all of the earnings have been distributed. Only after you have withdrawn all earnings do subsequent withdrawals represent a return of your original premium, which is tax-free.

For example, suppose you invested $100,000 in a non-qualified annuity and it has grown to $140,000. If you withdraw $20,000, the IRS considers that entire $20,000 to be earnings, and it is all taxed as ordinary income. If you later withdraw another $25,000, the first $20,000 of that withdrawal is taxable (the remaining earnings), and the last $5,000 is a tax-free return of your premium.

The LIFO rule makes partial withdrawals from a non-qualified annuity less tax-efficient than annuitization (converting to a stream of payments). If you plan to take money out gradually, the tax treatment may be more favorable if you annuitize the contract rather than take random withdrawals, because annuitization uses the exclusion ratio to spread the tax burden more evenly.

The Exclusion Ratio: Taxing Annuity Payments

When you annuitize a non-qualified annuity contract, converting your balance into a stream of regular payments, each payment is divided into two parts: a taxable earnings portion and a tax-free return of premium. The IRS uses the exclusion ratio to determine how much of each payment falls into each category.

The exclusion ratio is calculated by dividing your investment in the contract (your total after-tax premiums) by the expected return (the total amount you are expected to receive over your lifetime based on IRS life expectancy tables). For instance, if you invested $100,000 and the expected total return over your lifetime is $200,000, your exclusion ratio is 50 percent. This means 50 percent of each payment is tax-free (return of premium) and 50 percent is taxable (earnings).

The exclusion ratio applies to each payment until you have recovered your entire cost basis. Once your total tax-free portions equal your original investment, every subsequent payment becomes fully taxable. If you outlive the IRS life expectancy projection, you will receive payments that are 100 percent taxable. If you die before recovering your full cost basis, the unrecovered amount may be deductible on your final tax return.

The 10 Percent Early Withdrawal Penalty

If you withdraw earnings from an annuity before reaching age 59 and a half, the IRS imposes a 10 percent early withdrawal penalty on the taxable portion of the withdrawal. This penalty is in addition to regular income taxes owed on the earnings. The penalty is designed to discourage people from using tax-deferred savings before retirement.

There are several exceptions to the early withdrawal penalty. The penalty does not apply in cases of death (payments to a beneficiary), total and permanent disability, or if the withdrawal is part of a series of substantially equal periodic payments (SEPPs) under IRS Rule 72(t). Additionally, if an annuity is part of a qualified plan, other exceptions such as separation from service after age 55 may apply.

It is important to note that the 10 percent IRS penalty is separate from any surrender charges your insurance company may impose. If you withdraw money during the annuity's surrender period, you could owe both the IRS penalty and a surrender charge to the insurance company. This double hit can make early withdrawals very costly.

1035 Exchanges: Tax-Free Transfers Between Contracts

IRS Section 1035 allows you to transfer funds from one annuity contract to another without triggering a taxable event. This is called a 1035 exchange. The provision recognizes that you may want to move your annuity to a different company for better rates, lower fees, or different features without being penalized by taxes for doing so.

Eligible 1035 exchanges include annuity to annuity, life insurance to annuity, and annuity to long-term care insurance (added by the Pension Protection Act of 2006). You cannot exchange an annuity into a life insurance policy. The transfer must be a direct transfer between insurance companies. If the insurance company sends a check to you and you then deposit it into a new annuity, the IRS will treat the transaction as a withdrawal, and you will owe taxes on any gains.

When you complete a 1035 exchange, your cost basis from the old contract carries over to the new one. This means you are not losing any tax-free recovery of premium. However, be aware that a new surrender period will typically start with the new contract. If you are still in a surrender period on your current annuity, you may owe surrender charges to the old company. There is no limit on the number of 1035 exchanges you can make, but frequent exchanges may draw IRS scrutiny.

Inherited Annuity Tax Rules

When the owner of an annuity passes away, the tax treatment of the inherited annuity depends on the relationship between the beneficiary and the deceased owner. Unlike stocks and real estate, inherited annuities do not receive a step-up in cost basis. This means all deferred earnings inside the annuity will eventually be taxed as ordinary income to the beneficiary.

Spousal beneficiaries have the most favorable options. A surviving spouse can typically assume ownership of the annuity and continue the contract as if they were the original owner. This allows the tax-deferred growth to continue and postpones all taxation until the surviving spouse takes withdrawals. The spouse can also choose to receive a lump sum or take distributions over time.

Non-spouse beneficiaries have more limited options. They generally must withdraw the entire value of the annuity within five years of the owner's death or elect to receive the balance as a life annuity (a stream of payments over their lifetime). The taxable portion of each payment or withdrawal is taxed as ordinary income. A non-spouse beneficiary cannot continue the contract indefinitely. The specific options available depend on the annuity contract and the insurance company's rules.

For both qualified and non-qualified inherited annuities, the tax impact can be significant. A large lump-sum distribution could push the beneficiary into a higher tax bracket for that year. Spreading distributions over time, when the contract allows it, is often more tax-efficient. Consult a tax professional for advice specific to your situation regarding inherited annuity distributions.

Required Minimum Distributions and Annuities

Whether your annuity is subject to required minimum distributions depends entirely on how it is funded. Non-qualified annuities, which are purchased with after-tax money outside of a retirement account, do not have RMDs. You can let the money grow tax-deferred for as long as you want without being forced to take distributions.

Qualified annuities held inside a traditional IRA, 401(k), or other pre-tax retirement account are subject to the same RMD rules as the host account. This means you must begin taking minimum distributions at age 73. If your annuity is inside an IRA, its value is included in the total IRA balance used to calculate your annual RMD.

One useful strategy is annuitizing a qualified annuity contract into lifetime payments. If the annuity payments meet or exceed the RMD amount for that portion of the account, the payments can satisfy your RMD requirement. This turns a mandatory tax rule into a source of guaranteed lifetime income. However, the annuitization must meet IRS requirements for minimum distribution payments, so work with your insurance company and a tax professional to ensure compliance.

Key Takeaways for Tax-Smart Annuity Planning

Annuity taxation can be summarized in a few guiding principles. All annuity earnings are taxed as ordinary income, never as capital gains. Non-qualified annuities use LIFO ordering on withdrawals, meaning earnings come out first and are fully taxable. Annuitization spreads the tax burden more evenly through the exclusion ratio. The 10 percent early withdrawal penalty applies before age 59 and a half. A 1035 exchange lets you move between annuity contracts without triggering taxes. Inherited annuities do not receive a step-up in cost basis. And non-qualified annuities are not subject to required minimum distributions.

Every decision about your annuity — when to take withdrawals, whether to annuitize, how to structure a 1035 exchange, and how to plan for beneficiaries — has tax implications. Small differences in strategy can result in meaningful differences in your after-tax income. Consult a tax professional for advice specific to your situation before making any changes to your annuity contract or taking distributions.