How Are Annuities Taxed? A Plain-English Guide to the Rules

How an annuity is taxed comes down to two questions: where the money came from, and how you take it out. If you bought the annuity with money that has never been taxed (inside an IRA or a workplace plan), nearly every dollar you withdraw is taxed as ordinary income. If you bought it with money you had already paid tax on, only the growth is taxed, and your original contribution comes back to you tax-free. On top of that, the order in which earnings and principal are treated, and your age when you withdraw, change the result. This guide walks through each case using illustrative figures only. Tax rules and rates change, so confirm the current position with the IRS or a tax professional before acting.

Annuities are tax-deferred while the money stays inside the contract, which is one of their main selling points. Deferral is not the same as tax-free, though. The tax does not disappear; it is paid later, when you take the money out. Understanding the timing and the character of that future tax is the whole game.

Qualified vs Non-Qualified: The First Question

The single biggest factor is whether your annuity is qualified or non-qualified.

A qualified annuity is held inside a tax-advantaged retirement account, such as a traditional IRA, 401(k), or 403(b). The money that went in was generally pre-tax, so it has never been taxed. Because of that, when you withdraw, the IRS treats essentially the entire payment as taxable ordinary income. The annuity does not get special treatment here; it follows the rules of the account that holds it. If you want the wider context on these accounts, see our guide to tax-advantaged retirement accounts.

A non-qualified annuity is bought with after-tax money, outside a retirement account. You already paid income tax on the dollars you used to fund it. That original amount is your cost basis, and it comes back to you tax-free. Only the earnings on top are taxable. This is the case where the more detailed rules below come into play.

So the first thing to establish about any annuity is which bucket it sits in. The answer changes nearly everything that follows.

Non-Qualified Withdrawals: The LIFO Rule

When you take a partial withdrawal or a surrender from a deferred non-qualified annuity, the IRS generally applies a last-in, first-out (LIFO) order. In plain terms, earnings are treated as coming out first, and they are fully taxable as ordinary income. Only once all the earnings have been withdrawn do you start drawing on your original after-tax contribution, which is not taxed again.

A simple illustration: suppose you put $50,000 of after-tax money into a deferred annuity and it has grown to $70,000. The $20,000 of growth is considered to come out first and is taxable. The remaining $50,000, once you reach it, is a return of basis and is not taxed. These figures are an example only, not a quote; your actual numbers depend on your contract and how much it has grown.

This LIFO ordering is why taking ad-hoc withdrawals from a non-qualified deferred annuity can produce a larger tax bill up front than people expect. It is the opposite of how a brokerage account works, where you can often sell specific lots.

Annuitized Income: The Exclusion Ratio

The picture changes when you convert a non-qualified annuity into a stream of income payments, a process called annuitization. Here the IRS uses an exclusion ratio so that each payment is split into a tax-free return of your basis and a taxable portion of earnings.

Conceptually, the exclusion ratio is your investment in the contract divided by the total amount you are expected to receive over the life of the payments. That fraction of each payment is excluded from tax; the rest is taxed as ordinary income. The aim is to spread your tax-free basis evenly across the payments rather than front-loading the tax as LIFO does.

One important detail: the exclusion applies until you have recovered your entire basis. If you live beyond your life expectancy and keep receiving payments, later payments generally become fully taxable because your basis is used up. If you die before recovering all your basis, the unrecovered amount may be deductible on a final return. These mechanics are why annuitized income often has a gentler year-to-year tax profile than lump-sum withdrawals. To understand the difference between taking income now versus later, see immediate vs deferred annuities.

The Age-59½ Rule and the 10% Penalty

Separate from income tax, the IRS generally adds a 10% early-distribution penalty on the taxable portion of an annuity withdrawal taken before age 59½. The key word is taxable: the penalty applies to earnings, not to your return of after-tax basis.

This rule mirrors the early-withdrawal penalty on retirement accounts and exists to discourage tapping tax-deferred money early. There are limited exceptions, and the rules interact with your specific situation, so treat 59½ as the general threshold and verify exceptions with the IRS. For younger savers weighing an annuity against a more accessible product such as a CD, this penalty is a major reason to consider alternatives.

Remember that this penalty is on top of ordinary income tax, not instead of it. A pre-59½ withdrawal of earnings can therefore be taxed at your marginal rate plus the 10% penalty.

How Different Annuity Types Are Taxed

The type of annuity affects the details but not the core principles.

• Fixed and multi-year guaranteed annuities (MYGAs). Growth is credited at a set rate and deferred until withdrawal, then taxed under the rules above.
• Variable annuities. Investment gains inside the contract grow tax-deferred regardless of how often the underlying subaccounts are traded. When you withdraw, gains are taxed as ordinary income, not at capital-gains rates, which is a frequently missed point. See variable annuities explained.
• Immediate annuities. A non-qualified immediate annuity uses the exclusion ratio from the first payment, so part of each payment is tax-free basis and part is taxable earnings.
• Qualified annuities of any type. Held in a pre-tax account, withdrawals are generally fully taxable as ordinary income, and required minimum distribution rules eventually apply to the account.

Across all of these, the consistent theme is that annuity earnings are taxed as ordinary income when withdrawn, never as long-term capital gains. That trade — deferral now in exchange for ordinary-income treatment later — is central to deciding whether an annuity fits your plan.

Death Benefits and Inherited Annuities

Annuities do not get the step-up in cost basis that many other inherited assets receive. When a beneficiary inherits a non-qualified annuity, the deferred earnings remain taxable as ordinary income; the beneficiary pays tax on the gain as it is received. A spouse who is the beneficiary often has the option to continue the contract and keep deferring, while non-spouse beneficiaries generally must take the money out within a set period. The specifics depend on the contract and current rules, which is why beneficiaries should get advice before choosing how to receive the money. The available payout choices for an inherited annuity are worth reviewing carefully before deciding.

For qualified annuities held inside retirement accounts, inherited-account distribution rules apply on top of the income-tax treatment, and those rules have changed in recent years. Confirm the current requirements before acting.

Reporting: What Forms to Expect

The insurer reports taxable annuity distributions to you and to the IRS on Form 1099-R each year you take money out. The form shows the gross distribution and the taxable amount, though the taxable amount box is not always completed correctly for non-qualified contracts, so keep your own record of basis. If you exchange one annuity for another, that can be done as a tax-free 1035 exchange when the rules are followed, which preserves your basis and defers tax; a poorly executed exchange can trigger tax, so handle it carefully. For how annuity income fits into a broader plan, see our retirement tax planning guide.

Because annuity earnings are taxed as ordinary income on withdrawal, the timing of those withdrawals matters for managing your bracket year to year. That is a planning question worth modelling before you start drawing.

This article is educational and not personal financial advice. Annuity tax rules are detailed and change over time; confirm the current treatment with the IRS, the insurer, or a qualified tax professional before acting on anything here.

How Annuities Are Taxed: Frequently Asked Questions

Do you pay taxes on annuity withdrawals?

It depends on the source of the money. In a qualified annuity funded with pre-tax dollars, withdrawals are generally fully taxable as ordinary income. In a non-qualified annuity funded with after-tax dollars, only the earnings are taxable; your original contribution comes back tax-free. The order and method differ between lump-sum withdrawals (LIFO) and annuitized income (the exclusion ratio).

Are annuity earnings taxed as capital gains?

No. Earnings withdrawn from an annuity are taxed as ordinary income, not at long-term capital-gains rates, even in a variable annuity where the underlying investments might otherwise qualify for capital-gains treatment. This is an important trade-off to weigh when comparing an annuity with a taxable investment account.

What is the 10% penalty on annuities?

The IRS generally applies a 10% early-distribution penalty to the taxable (earnings) portion of an annuity withdrawal taken before age 59½, on top of ordinary income tax. It does not apply to the return of your after-tax basis. Limited exceptions exist, so check the current rules with the IRS.

Is an inherited annuity taxable?

Generally yes, on the deferred earnings. Annuities do not receive a step-up in basis at death, so a beneficiary pays ordinary income tax on the gain as it is received. Spousal and non-spousal beneficiaries have different continuation and payout options, and the rules change, so confirm your position before choosing how to take the money.