An after-tax annuity is an insurance contract you buy with money you’ve already paid income tax on, which is why the IRS calls it a non-qualified annuity. Because the premium is post-tax, only the growth inside the contract is ever taxed again. The earnings compound tax-deferred while they stay in the contract, and there is no annual contribution cap and no income limit on who can buy one.
Basis and Earnings: The Split That Drives Every Tax Rule
Every dollar of premium you pay is tracked as your investment in the contract, sometimes called your cost basis. That money will not be taxed a second time when it comes back to you. What the IRS taxes is the growth stacked on top of your basis: interest, dividends, and gains that accumulated inside the contract.
Keep your contribution records. The split between basis and earnings decides how much of every future dollar is taxable, and the rules for identifying which part is coming out change depending on how you take the money.
Taxes on Income Payments: The Exclusion Ratio
When you annuitize the contract and start receiving regular payments, the IRS uses an exclusion ratio to divide each check into a tax-free return of basis and a taxable earnings piece. The formula divides your total investment in the contract by the expected return over the payout period, and the resulting percentage applies to every payment.1Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (b) Exclusion Ratio
Say you invested $100,000 and your expected return over your lifetime is $200,000. Your exclusion ratio is 50 percent. Half of each payment is tax-free; the other half is ordinary income, taxed at your marginal rate between 10 and 37 percent under current brackets.2Internal Revenue Service. Federal Income Tax Rates and Brackets Once you’ve recovered your full basis, every dollar after that is fully taxable.
Taxes on Withdrawals Before You Annuitize
If you take money out before converting the contract into an income stream, the math flips against you. Federal law treats pre-annuitization withdrawals on an earnings-first basis. Every dollar you pull is taxable income until you’ve withdrawn all of the accumulated gains. Only after the gains are exhausted can you tap your original basis tax-free.3Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (e) Amounts Not Received as Annuities
That ordering is roughly the opposite of a Roth IRA, where contributions come out first. In practice, an early partial withdrawal from a non-qualified annuity is almost always 100 percent taxable unless the contract has actually lost money.
The 10 Percent Early Withdrawal Penalty
On top of ordinary income tax, the IRS adds a 10 percent penalty on the taxable portion of any withdrawal taken before you turn 59½. The penalty applies only to the taxable piece, not the full amount. Exceptions exist for distributions made after the owner’s death, because of a qualifying disability, or as part of a series of substantially equal periodic payments spread over your life expectancy.4Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (q) 10-Percent Penalty for Premature Distributions
How the Distribution Is Reported
Whenever the insurer pays you, it files a Form 1099-R with the IRS and sends you a copy. The form separates the taxable portion from the return of basis so you have the numbers you need at tax time.5Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Two Extra Taxes on Large Distributions
Ordinary income tax and the 10 percent penalty get most of the attention. Two other consequences catch owners off guard when the distribution is big.
The 3.8 Percent Net Investment Income Tax
Taxable income from a non-qualified annuity counts as net investment income. If your modified adjusted gross income is above $200,000 (single) or $250,000 (married filing jointly), the taxable portion of your distribution picks up an additional 3.8 percent surtax on top of your regular rate.6Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Those thresholds are not indexed for inflation, so more filers cross them every year.
Medicare Premium Surcharges
A large annuity distribution can push your modified adjusted gross income high enough to trigger Income-Related Monthly Adjustment Amounts on Medicare Part B and Part D. The Social Security Administration sets the surcharge from your tax return two years earlier. For 2026, individuals with modified adjusted gross income above $109,000 (or $218,000 for joint filers) pay more than the standard $202.90 Part B premium, with surcharges climbing through five income tiers up to $689.90 per month.7Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles Spreading withdrawals across tax years can keep you under the trigger.
Switching Contracts Without a Tax Bill: 1035 Exchanges
If you’re unhappy with your annuity’s fees, performance, or features, you don’t have to cash it out and pay tax on the gains. Federal law allows a tax-free direct transfer from one non-qualified annuity to another, or from an annuity to a qualified long-term care insurance policy, without recognizing any gain.8Office of the Law Revision Counsel. 26 U.S.C. 1035 – Certain Exchanges of Insurance Policies The money has to move directly between insurers. If the check passes through your hands, the IRS treats it as a taxable withdrawal followed by a new purchase, and you lose deferral on the accumulated gains.
Surrender Charges Stack on Top of Taxes
Insurers impose their own surrender charges when you withdraw during the early years of the contract. A common schedule starts at 7 percent in year one and drops one percentage point each year, reaching zero after six to eight years. Some contracts run a full ten years.9U.S. Securities and Exchange Commission. Updated Investor Bulletin: Variable Annuities
Most contracts let you take up to 10 percent of the account value each year without a surrender fee. Anything above the free-withdrawal allowance gets hit at the current year’s surrender rate. This charge is separate from the IRS penalty for distributions before age 59½. You can owe both at once. Read the surrender schedule before buying; a 7 percent surrender charge layered on income tax and a 10 percent early-withdrawal penalty can wipe out years of tax-deferred growth in a single withdrawal.
Who Can Own the Contract
Tax deferral is available only when a “natural person” owns the contract. If a corporation, LLC, or trust holds the annuity and is not acting as an agent for an individual, the contract loses its annuity tax treatment. The insurer still runs the money, but the IRS taxes the annual gain as ordinary income to the entity each year, whether or not anything is withdrawn.10Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (u) Treatment of Annuity Contracts Not Held by Natural Persons Trusts set up for estate planning sometimes fall into this by accident. If the trust holds the annuity as an agent for a living person, the statute carves out an exception, but the titling has to be right from the start.
What Beneficiaries Owe When You Die
Non-qualified annuities do not get a stepped-up basis at death the way stocks and real estate can. The beneficiary inherits the contract along with the embedded tax on all accumulated gains. How fast that tax comes due depends on timing.
If the owner dies before annuity payments have begun, the entire balance has to be distributed within five years. An exception applies if a designated beneficiary elects to receive distributions over their own life expectancy and starts within one year of the owner’s death. This stretch option spreads the tax over many years instead of concentrating it in one large lump sum.11Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: (s) Required Distributions Where Holder Dies Before Entire Interest Is Distributed
If the owner dies after annuity payments have already started, the remaining payments must continue at least as fast as the original schedule. A surviving spouse named as beneficiary generally has the most flexibility and may be able to continue the contract as the new owner, keeping deferral alive on the remaining gains. Non-spouse beneficiaries do not have that option. Naming beneficiaries carefully and walking them through the payout election in advance can prevent a five-figure tax surprise at exactly the wrong moment.