Are Annuities Taxed as Capital Gains or Ordinary Income?

Annuity earnings are taxed as ordinary income, not as capital gains. The question of whether annuities are taxed as capital gains or ordinary income has a clean answer, and it matters: for 2026, ordinary income rates run from 10% to 37%, while long-term capital gains top out at 20% for most investors.¹ How much of each withdrawal actually gets taxed depends on how the contract was funded, how you take the money out, and how old you are when you do it.

Why Capital Gains Rates Don’t Apply

Capital gains rates apply when you sell a capital asset you’ve held for more than a year, like stock or real estate.² Annuity growth doesn’t come from selling an asset. It comes from interest, bond returns, or sub-account gains that build up inside the contract without being taxed each year. The IRS treats that accumulated growth as deferred income, and when you finally pull it out, it’s taxed at your ordinary rate.

That tradeoff is the price of tax deferral. In a regular brokerage account, you’d owe tax every year on dividends, interest, and realized gains. Inside an annuity, those taxes are postponed, sometimes for decades. The IRS doesn’t give you deferral and preferential rates. You get one or the other, and annuities get deferral.

The taxable portion of every annuity distribution gets stacked on top of your other income for the year, including wages, pensions, and Social Security. Your marginal rate on the withdrawal depends on where total income lands in the 2026 brackets, which start at 10% on the first $12,400 of taxable income (single filer) and reach 37% above $640,600.¹

How Much of a Withdrawal Is Actually Taxable

“Ordinary income” doesn’t automatically mean every dollar is taxed. The taxable share depends on whether the annuity is qualified, non-qualified, or held inside a Roth account.

Qualified Annuities

A qualified annuity sits inside a tax-advantaged retirement account like a traditional IRA or 401(k). Because the contributions were made with pre-tax dollars, the IRS has never taxed any of the money. Every dollar you withdraw is fully taxable as ordinary income, original contributions and earnings alike.³ If you contributed $200,000 over the years and the contract grew to $350,000, you owe income tax on the full $350,000 as you take it out.

Non-Qualified Annuities

A non-qualified annuity is one you bought directly from an insurance company using money you’d already paid tax on. Since the premiums were already taxed, the IRS only taxes the earnings when you withdraw. Your original investment, the cost basis, comes back tax-free.⁴ The split between taxable earnings and tax-free basis is the key difference from a qualified contract, but the mechanics of that split depend on how you take the money.

Roth Annuities

Annuities held inside a Roth IRA or designated Roth 401(k) follow Roth rules rather than ordinary annuity rules. Qualified distributions come out entirely tax-free, which means the earnings genuinely escape income tax altogether.³ A distribution counts as qualified when you’ve held the Roth account at least five years and you’re at least 59½ (or the distribution is due to death or disability). This is the one scenario where annuity growth beats both the ordinary-income and the capital-gains outcome.

Two Methods for Taxing Non-Qualified Distributions

With a non-qualified contract, the IRS uses two completely different methods to figure out how much of a distribution is taxable. Which one applies depends on whether you’re taking a withdrawal from the contract or receiving structured annuity payments.

Withdrawals Before Annuitization

If you take a partial withdrawal or surrender from a non-qualified annuity before converting it into a payment stream, the IRS treats the first dollars out as earnings. The tax code specifically requires that any amount received before the annuity starting date be included in gross income to the extent it’s allocable to income on the contract.⁵ Only after you’ve withdrawn all the accumulated earnings does the IRS treat later withdrawals as a tax-free return of basis.

In practice, early withdrawals are often 100% taxable. If you invested $100,000 and the contract grew to $140,000, the first $40,000 you take out is fully taxable as ordinary income. The remaining $100,000 then comes out tax-free.⁴

Annuitized Payments and the Exclusion Ratio

When you annuitize a non-qualified contract, converting it into a stream of payments over your lifetime or a set period, each payment splits into a taxable and a tax-free portion using the exclusion ratio. The ratio is your total cost basis divided by the expected total return.⁶

Expected return is figured using IRS life expectancy tables. If you invested $100,000 and the expected total payout over your projected lifetime is $250,000, the exclusion ratio is 40%. That means 40% of every monthly payment is tax-free basis coming back, and the other 60% is taxable ordinary income. The ratio stays fixed for the life of the payments.

Two scenarios matter at the tail end. If you outlive the life expectancy in the calculation, every payment becomes fully taxable once you’ve recovered your entire basis. If you die before recovering it, the unrecovered amount is deductible on your final tax return.⁴

The 10% Early Withdrawal Penalty

Taking money out of an annuity before age 59½ triggers a 10% additional tax on top of the regular income tax you’d owe. The penalty applies only to the taxable portion of the distribution.⁵ For a non-qualified contract, that’s the earnings. For a qualified contract, where the entire withdrawal is taxable, it hits the full amount.

The penalty operates under two separate code sections: Section 72(q) governs non-qualified annuities, and Section 72(t) covers qualified retirement plan distributions. The distinction matters because the exceptions differ. Both sections exempt distributions made after the owner’s death or due to disability, and both allow penalty-free withdrawals under the Substantially Equal Periodic Payments (SEPP) rule, which lets you take a calculated series of payments based on life expectancy for at least five years or until you reach 59½, whichever comes later.⁷ Changing the payment schedule before satisfying both conditions triggers a recapture tax on all the penalties you previously avoided.

Qualified annuities under Section 72(t) carry additional exceptions, including distributions used for medical expenses above 7.5% of adjusted gross income.⁵ Non-qualified annuities under Section 72(q) have a narrower list, so don’t assume a penalty exemption you’ve read about for IRAs also applies to a contract you bought from an insurer.

The 3.8% Net Investment Income Surtax

Higher-income taxpayers face an extra layer on non-qualified annuity earnings. The taxable portion of distributions from a non-qualified annuity counts as net investment income under IRC Section 1411, which imposes a 3.8% surtax when your modified adjusted gross income exceeds certain thresholds.⁸

The thresholds are $200,000 for single filers and $250,000 for married couples filing jointly, and they aren’t indexed for inflation.⁹ A large annuity withdrawal that pushes your income over those lines can expose both the annuity income and your other investment income to the surtax.

Qualified plan distributions, including those from annuities held inside a traditional IRA or 401(k), are specifically excluded from net investment income.⁸ For people with income above the thresholds, that’s one area where qualified contracts have an edge.

What Heirs Owe on an Inherited Annuity

Annuities do not receive a step-up in basis at the owner’s death. That’s one of the biggest differences between annuities and assets like stocks or real estate. The beneficiary inherits the original owner’s cost basis, and the earnings inside the contract remain taxable as ordinary income.⁴ People get tripped up here, assuming the tax slate wipes clean at death the way it does with most other investments.

The taxation principle stays consistent regardless of the payout method the beneficiary chooses. For non-qualified contracts, only the earnings above the cost basis are taxable. For qualified contracts, the entire distribution is ordinary income. The beneficiary reports the income the same way the original owner would have.⁴

1
Internal Revenue Service. Tax Inflation Adjustments for Tax Year 2026
2
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
3
Internal Revenue Service. Topic No. 410, Pensions and Annuities
4
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
5
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
6
eCFR. 26 CFR 1.72-4 – Exclusion Ratio
7
Internal Revenue Service. Substantially Equal Periodic Payments
8
eCFR. Net Investment Income Tax
9
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax