Are Variable Annuities Tax-Deferred and How Are They Taxed

A variable annuity grows tax-deferred, and variable annuity taxation kicks in only when money comes out: gains are then taxed as ordinary income at your federal rate, not at the lower long-term capital gains rates that apply in a regular brokerage account. Withdrawals before age 59½ generally carry an extra 10% penalty, and several other rules, from required distributions to a 3.8% surtax on higher earners, can change what you actually keep.

How Tax Deferral Works While the Money Grows

While your money stays inside the contract, you won’t get a 1099 each year for dividends, interest, or realized gains. The subaccounts can buy and sell investments and distribute capital gains internally without a taxable event for you. Under Internal Revenue Code Section 72, the contract is treated as a single wrapper, and nothing is taxable until a distribution actually leaves it.¹

In a taxable brokerage account, you’d owe tax every year on dividends and on gains from rebalancing. Inside a variable annuity, those same transactions produce no current tax bill, so every dollar that would have gone to the IRS stays invested. Over a long accumulation period, that compounding can be meaningful.

There’s a real trade-off. When you eventually withdraw, every dollar of gain is taxed as ordinary income. You lose access to the preferential long-term capital gains rates you’d get in a taxable account. Whether the deferral outweighs that rate disadvantage depends on your time horizon and your expected bracket in retirement.

Qualified vs. Non-Qualified Contracts

How your withdrawals are taxed depends almost entirely on how the annuity was funded.

Qualified Annuities

A qualified variable annuity sits inside a tax-advantaged retirement account such as a traditional IRA or 401(k). The money that went in was pre-tax or tax-deductible, so the IRS has never taxed any of it. When you withdraw, every dollar is taxed as ordinary income at your current federal rate, which for 2026 ranges from 10% to 37%.² Because the contract lives inside a retirement account, the contribution limits of that account apply.

Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax dollars outside any retirement plan. Because you already paid income tax on the money going in, only the earnings portion of a withdrawal is taxable. Your original contributions, called your cost basis or investment in the contract, come back to you tax-free.³

Non-qualified contracts have no federal contribution limits, which is why they appeal to people who’ve already maxed out their IRA and 401(k). The tax benefit is purely the deferral of gains, not a deduction on the front end.

How Withdrawals Are Taxed

The IRS uses different accounting methods depending on the type of contract and whether you’re taking lump-sum withdrawals or annuitized payments.

Partial Withdrawals From Non-Qualified Contracts

Take a partial withdrawal from a non-qualified contract before annuitizing, and the IRS treats earnings as coming out first. If your contract is worth $200,000 and your cost basis is $150,000, the first $50,000 you withdraw is fully taxable because it represents gains. Only after you’ve pulled out all the earnings do further withdrawals become a tax-free return of principal.³

This is sometimes called a “last-in, first-out” rule. Early withdrawals carry the highest tax hit.

Annuitized Payments and the Exclusion Ratio

If you convert the contract into a stream of periodic payments, the math changes. The IRS lets you spread your cost basis across the expected number of payments using an exclusion ratio. Part of each payment is treated as a tax-free return of your investment, and the rest is taxable as ordinary income.⁴ The tax-free fraction stays the same each year. Once your entire cost basis has been recovered, every subsequent payment is fully taxable.

Extra Withdrawals After Payments Have Started

If you’ve begun receiving annuity payments and then take a lump-sum withdrawal on top of them, the entire extra amount is generally taxable. Anything outside the regular payment stream, once the annuity starting date has passed, is treated as fully taxable.³

The 10% Early Withdrawal Penalty

Pull money out before age 59½ and the IRS adds a 10% penalty on top of the income tax. For non-qualified annuities the penalty comes from IRC Section 72(q) and applies to the taxable earnings portion. For qualified annuities held inside an IRA or 401(k), the parallel rule is Section 72(t).⁵

The math adds up fast. In the 22% federal bracket, a $20,000 early withdrawal that’s entirely earnings would trigger $4,400 in income tax plus a $2,000 penalty, a 32% combined federal rate before any state tax.

Exceptions

Several situations waive the 10% penalty, though the taxable portion still owes regular income tax:

Total and permanent disability.⁶
A series of substantially equal periodic payments (SEPP) calculated over your life expectancy. Once you start, you must continue for at least five years or until you turn 59½, whichever comes later. Stopping or modifying the payments early triggers a recapture tax on every penalty you had previously avoided.⁷
Distributions paid to a beneficiary after the owner’s death.
Unreimbursed medical expenses above 7.5% of your adjusted gross income.⁶
Immediate annuities purchased with a single premium where payments begin within one year.⁵

Surrender charges written into the contract itself are a separate matter from the tax penalty and can apply on top of it. Check your contract’s surrender schedule before taking any distribution.

The 3.8% Net Investment Income Tax

Higher earners face a surtax. Taxable distributions from non-qualified variable annuities count as net investment income for the 3.8% Net Investment Income Tax (NIIT). You owe it if your modified adjusted gross income exceeds $200,000 filing single or $250,000 filing jointly.⁸

Distributions from qualified annuities inside IRAs or employer plans are generally not net investment income and are not subject to the NIIT. If you’re above the thresholds, a large non-qualified withdrawal could push your effective federal rate on that money above 40% once ordinary income tax and the surtax are combined.

Required Minimum Distributions

Qualified variable annuities held inside traditional IRAs and similar retirement accounts are subject to required minimum distribution rules. You must begin annual withdrawals at age 73. For those born in 1960 or later, the starting age becomes 75.⁹

Missing an RMD triggers a 25% excise tax on the amount you should have withdrawn. Correct the shortfall within two years and the penalty drops to 10%.⁹ You can delay your first RMD until April 1 of the following year, but that means two RMDs in the same tax year, which can push you into a higher bracket.

Non-qualified variable annuities have no federal RMD requirement during the owner’s lifetime. The money can keep growing tax-deferred indefinitely if you don’t need it.

Switching Contracts With a 1035 Exchange

If you’re unhappy with your current contract’s fees, investment options, or insurer, you don’t have to cash out and pay tax. IRC Section 1035 lets you exchange one annuity for another without recognizing gain or loss, provided the exchange goes directly from one insurer to another and the same owner remains on the new contract.¹⁰

You can also exchange a variable annuity for a qualified long-term care insurance contract. You can’t go the other direction: an annuity-to-life-insurance swap doesn’t qualify.

Partial 1035 exchanges are allowed. You can transfer part of an existing contract’s value directly to a new one, but you can’t take a withdrawal from either contract during the 180 days after the transfer. Break that window and the IRS may recharacterize the whole thing as a taxable withdrawal plus a new purchase.¹¹

Taxation of Death Benefits

When a variable annuity owner dies, the death benefit passes to the named beneficiary. Unlike life insurance proceeds, which are generally income-tax-free, annuity death benefits are taxable to the extent the payout exceeds the owner’s cost basis. The beneficiary owes ordinary income tax on the gains, just as the original owner would have.³

No Step-Up in Basis

Most inherited assets like stocks and real estate receive a step-up in basis to fair market value at the date of death, which wipes out unrealized gains. Annuities are explicitly excluded from that benefit under IRC Section 1014(b)(9)(A).¹² The beneficiary inherits the original cost basis and owes tax on the full amount of accumulated gains. It is one of the most commonly overlooked drawbacks in estate planning.

Beneficiary Options

A surviving spouse typically has the most flexibility. Most contracts let a spouse continue the annuity as the new owner, preserving deferral and avoiding an immediate taxable event. A spouse can also take a lump sum or annuitize.

Non-spouse beneficiaries generally cannot continue the contract. For qualified annuities inside an IRA, a non-spouse beneficiary must distribute the entire balance within 10 years of the owner’s death. If the original owner had already begun RMDs, the beneficiary also has to take annual distributions during that 10-year window.¹³ For non-qualified annuities, options typically include a lump sum, a five-year distribution period, or payments stretched over the beneficiary’s life expectancy.

Beneficiaries receiving inherited annuity distributions are not subject to the 10% early withdrawal penalty regardless of age. That exception disappears if a surviving spouse elects to become the new owner rather than taking the proceeds as a beneficiary.

Two Rules That Catch Owners Off Guard

The Aggregation Rule

If you own multiple non-qualified annuity contracts issued by the same insurance company in the same calendar year, the IRS treats them as a single contract when it calculates the taxable portion of any withdrawal. This aggregation rule under IRC Section 72(e)(12) blocks the strategy of splitting money across contracts to withdraw selectively from one with a low gain.⁵ Contracts from different insurers, or from the same insurer in different calendar years, are not aggregated. The rule doesn’t reach annuities inside qualified retirement plans.

Contracts Owned by Corporations or Trusts

Tax deferral disappears when a variable annuity is owned by a non-natural person such as a corporation, LLC, or certain trusts. Under IRC Section 72(u), the contract is not treated as an annuity for tax purposes, and the annual increase in value is taxed as ordinary income to the owner each year.⁵ Exceptions exist for contracts held by an estate, inside qualified plans, or by a trust acting as agent for a natural person, and for immediate annuities. Verify the ownership structure before buying, because a garden-variety entity-owned annuity loses the core tax benefit that makes the product worth owning.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
4
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
5
Office of the Law Revision Counsel. 26 US Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
6
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
7
Internal Revenue Service. Substantially Equal Periodic Payments
8
Internal Revenue Service. Net Investment Income Tax
9
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
10
Office of the Law Revision Counsel. 26 US Code 1035 – Certain Exchanges of Insurance Policies
11
Internal Revenue Service. Revenue Procedure 2011-38
12
Office of the Law Revision Counsel. 26 US Code 1014 – Basis of Property Acquired From a Decedent
13
Internal Revenue Service. Publication 590-B (2025), Distributions from Individual Retirement Arrangements (IRAs)