Are Annuity Payments Taxable? Rules, Penalties, and Withholding

Yes, annuity payments are taxable, but how much of each payment the IRS takes depends on how you funded the contract. Annuities bought inside a retirement account with pre-tax money are fully taxable as ordinary income, while annuities bought with after-tax dollars are only taxable on the earnings portion. For 2026, taxable annuity income falls under the regular federal brackets, which run from 10% to 37%.¹ Beyond the base tax, early withdrawals, high-income surcharges, and the effect on Social Security and Medicare can add real cost.

Qualified Annuities Are Fully Taxable

Qualified annuities live inside tax-advantaged retirement accounts: 401(k) plans, 403(b) plans, Traditional IRAs, and similar vehicles. Contributions went in before tax, so the IRS has never collected on any part of the balance. Every dollar you receive counts as ordinary income, including both your original contributions and all the growth.² The taxable amount appears in Box 1 of the Form 1099-R your insurer or plan administrator sends each January, and you report the full figure on your federal return.

Qualified annuities also trigger required minimum distributions starting at age 73.³ Miss one, and the IRS charges a 25% excise tax on the shortfall, reduced to 10% if you fix it within two years.⁴

Non-Qualified Annuities Are Only Partly Taxable

A non-qualified annuity is one you bought with money you had already paid income tax on. The IRS already got its share of your original contributions, so it only taxes the growth. Once you start taking payments under an annuitization schedule, each check splits into two pieces: a tax-free return of your original investment and a taxable portion representing earnings.⁵

The split holds steady until you’ve recovered your entire cost basis. After that, every payment is fully taxable.⁶ If you die before recovering your full basis, the unrecovered amount qualifies as an itemized deduction on your final tax return.²

Keeping accurate records of your basis matters. It includes every after-tax premium you paid into the contract. Lose track, and you could pay tax twice on money you already paid tax on, or underreport and face penalties. Hold on to the original contract, premium records, and every 1099-R.

How the Exclusion Ratio Splits Each Payment

The exclusion ratio is a simple fraction: your total investment in the contract divided by the expected return. Expected return is the total the contract is projected to pay you, calculated using IRS life expectancy tables for lifetime annuities or the fixed term for period-certain annuities.²

An example makes it concrete. You invested $100,000, and the contract’s expected return is $200,000. Your exclusion ratio is 50%. On a $1,000 monthly payment, $500 comes back tax-free and $500 counts as taxable income. That split continues until you’ve excluded a full $100,000, at which point the tax-free portion runs out and every remaining dollar becomes taxable.⁶

The IRS calculates the ratio using either the Simplified Method (covered in Publication 575) or the General Rule (Publication 939), which applies to annuities with start dates before November 19, 1996, and certain other situations.⁵

The 10% Penalty on Early Withdrawals

Pulling money out before age 59½ adds a 10% federal penalty on top of income tax on the taxable portion.⁷ If you’re in the 22% bracket and withdraw $10,000 of earnings, that’s $2,200 in income tax plus $1,000 in penalty, a combined 32% on the withdrawal.

For non-qualified annuities, the IRS uses an earnings-first rule on withdrawals taken before annuitization. The first dollars out are treated as earnings, not principal, so early withdrawals are almost always fully taxable.² For qualified annuities, everything is taxable regardless of ordering.

Exceptions That Waive the Penalty

The 10% penalty doesn’t apply in every early-withdrawal situation. For qualified annuities in IRAs or employer plans, common exceptions include:

Death or total and permanent disability of the account holder
Substantially equal periodic payments over your life expectancy, sometimes called 72(t) distributions
Unreimbursed medical expenses exceeding 7.5% of adjusted gross income
Up to $10,000 for a first-time home purchase (IRA distributions only)
Qualified higher education expenses (IRA distributions only)
Up to $22,000 in qualified disaster distributions
Up to $5,000 per child for a birth or adoption

You claim the exception on Form 5329.⁷

Non-qualified annuities have a narrower list under a different section of the code. The main exceptions are reaching age 59½, death, disability, and substantially equal periodic payments. The IRA-specific exceptions for education and first-time home purchases do not carry over to non-qualified contracts.

The IRS penalty is separate from any surrender charge the insurance company itself imposes on early withdrawals during the contract’s early years, which is a private contractual fee rather than a tax.

The 3.8% Net Investment Income Tax

Higher-income owners of non-qualified annuities face an extra 3.8% tax that catches many people off guard. The Net Investment Income Tax applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.⁸ The tax equals 3.8% of the lesser of your net investment income or the amount by which MAGI exceeds the threshold.⁹

These thresholds are not indexed for inflation, so more retirees cross them each year. Distributions from qualified annuities held inside retirement plans are generally not subject to the NIIT, but the taxable portion of non-qualified annuity payments counts as net investment income.⁵

What Beneficiaries Owe on Inherited Annuities

Tax treatment for beneficiaries depends on the contract type and the beneficiary’s relationship to the deceased.

For non-qualified annuities, 26 U.S.C. § 72(s) sets the timeline. If the owner dies before payments begin, the full contract value must be distributed within five years, unless a designated beneficiary elects to take payments over their own life expectancy with the first payment starting within one year of death.⁶ A surviving spouse can step into the contract as the new owner and keep it growing tax-deferred. If the owner dies after payments have started, the remaining payments must continue at least as fast as the existing schedule.

Qualified annuities follow the RMD rules that govern the underlying retirement account. A surviving spouse can roll the annuity into their own IRA or treat it as an inherited account. Non-spouse beneficiaries generally must empty the account within ten years under the SECURE Act, though some eligible designated beneficiaries can still stretch payments over their lifetime.¹⁰ Every dollar a beneficiary receives from a qualified annuity is taxable.

Taking a lump sum from either type of inherited annuity concentrates all the taxable income into one year and can push a beneficiary into a higher bracket. Stretching distributions over the longest available period usually produces the lowest total tax bill.

Effects on Social Security and Medicare

Annuity income doesn’t stop at its own tax bill. It can also raise the tax on your Social Security benefits and push up your Medicare premiums.

Social Security Benefits

The IRS uses a combined income formula: half your annual Social Security plus all other income, including annuity payments. Above $25,000 for single filers or $32,000 for joint filers, up to 50% of benefits become taxable. Above $34,000 (single) or $44,000 (joint), up to 85% become taxable.¹¹ These thresholds have never been adjusted for inflation, so a modest annuity payment stacked on other retirement income can be enough to push you across.

Medicare IRMAA Surcharges

Medicare Part B and Part D premiums increase for higher-income beneficiaries through Income-Related Monthly Adjustment Amounts, based on the modified adjusted gross income from the tax return filed two years earlier. For 2026, Part B surcharges begin when individual income exceeds $109,000 or joint income exceeds $218,000, scaling through five tiers.¹² At the top tier (income of $500,000 or more for single filers), the Part B surcharge alone reaches $487.00 a month, with a separate Part D surcharge of $91.00 on top.

A large one-year distribution, whether from cashing out or taking a lump-sum inherited annuity, can spike income enough to trigger IRMAA two years later. Spreading distributions across years, where possible, helps hold you under the thresholds.

Withholding on Annuity Payments

Insurers and plan administrators withhold federal income tax from annuity payments, but the defaults often fall short of what you actually owe. For periodic payments, withholding is calculated like wages using the information you submit on Form W-4P.¹³ If you don’t file a W-4P, the payer withholds as though you’re a single filer with no adjustments.

For non-periodic distributions such as lump-sum withdrawals or partial surrenders, the default withholding rate is only 10% of the taxable amount.¹⁴ If you’re in the 22% or 24% bracket, that leaves a real gap. You can adjust the rate on non-periodic payments using Form W-4R, choosing anywhere from 0% to 100%. Reviewing your withholding annually or making quarterly estimated payments can prevent an underpayment penalty at filing.

State Income Tax

Federal tax is only part of the total. Most states with an income tax also treat annuity distributions as taxable income, with rates from under 1% to over 13%. A handful of states have no income tax, and others offer partial exclusions for retirement income that can lower or eliminate state tax on annuity payments. Exclusions often depend on your age, the type of annuity, or your total retirement income, so checking your state’s specific rules before you begin distributions is worth the time.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
3
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
4
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
5
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
6
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
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Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax
9
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
10
Internal Revenue Service. Retirement Topics – Beneficiary
11
Internal Revenue Service. IRS Reminds Taxpayers Their Social Security Benefits May Be Taxable
12
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
13
Internal Revenue Service. Pensions and Annuity Withholding
14
Internal Revenue Service. 2026 Form W-4R