Are Variable Annuities Tax Deferred? Withdrawals, RMDs, Penalties

Yes, variable annuities are tax-deferred. Investment earnings inside the contract — dividends, interest, and capital gains from the sub-accounts — are not reported on your tax return while they stay in the annuity. You owe federal income tax only when money comes out, and how it’s taxed then depends on whether the annuity is held inside a retirement plan or funded with after-tax dollars.

What Tax Deferral Covers While the Money Is Inside

During the accumulation phase, none of the internal investment activity hits your tax return. Sub-account dividends compound, interest compounds, and gains on rising fund values compound, all without an annual tax bill.¹ You can also move money between sub-accounts — say, from a stock fund to a bond fund — and the shift is not a taxable event.²

There is a trade-off built into that deferral. When earnings eventually come out, they’re taxed as ordinary income rather than at the lower long-term capital gains rates that would apply if you held similar investments in a regular brokerage account.² Deferral lets your gains keep working, but it does not convert them into capital gains.

How Withdrawals Are Taxed

The rules split cleanly along one line: was the annuity bought with pre-tax retirement money or with after-tax dollars?

Qualified Variable Annuities

A qualified variable annuity sits inside a tax-advantaged plan such as a 401(k), 403(b), or traditional IRA. Because none of the money going in has been taxed, every dollar coming out is fully taxable as ordinary income at your marginal rate.³ There is no tax-free portion because nothing in the account has ever been taxed.

Non-Qualified Variable Annuities

A non-qualified annuity is bought with after-tax money, so the IRS has already taxed your original contributions. Only the earnings portion of a withdrawal is taxable; your original investment eventually comes back tax-free.³

The catch is the ordering rule. For partial withdrawals, the IRS uses a last-in, first-out approach: every dollar you take out is treated as earnings first and taxed as ordinary income, until you’ve pulled out all the accumulated gains. Only after the remaining balance drops to your original investment can you withdraw tax-free.³

Buying more than one non-qualified annuity from the same insurer in the same calendar year does not get around this. The IRS treats those contracts as a single contract when figuring the taxable portion of withdrawals.⁴ Contracts from different insurers, or from the same insurer in different calendar years, are tracked separately.

If You Annuitize Instead of Taking Withdrawals

When you convert a non-qualified annuity into a stream of periodic payments, the LIFO rule stops applying. The IRS instead uses an exclusion ratio that splits each payment into a tax-free return of your original investment and a taxable earnings portion.⁵ The formula divides your after-tax investment by the expected return over the payout term. If the result is 40%, then 40 cents of every dollar is tax-free and 60 cents is ordinary income. That ratio holds until you’ve recovered your full investment; if payments continue after that, they are fully taxable.⁶

The 10% Penalty for Withdrawing Before 59½

Deferral has a lower age limit. Pulling money out of a variable annuity before age 59½ adds a 10% federal penalty on top of the ordinary income tax due on the taxable portion.⁵ For a non-qualified annuity, the penalty hits the earnings portion. For a qualified annuity, it hits the entire distribution because the whole distribution is taxable.

The stacking matters. Someone in the 24% bracket who takes out $10,000 in earnings before 59½ owes $2,400 in ordinary income tax plus a $1,000 penalty — a combined 34% before any state tax.

A few situations avoid the penalty:

Distributions to a beneficiary after the owner’s death.
Withdrawals made because the owner becomes disabled.
A schedule of substantially equal periodic payments based on life expectancy. Once started, the schedule must run for at least five years or until you reach 59½, whichever is later. Modifying or stopping it early triggers a retroactive recapture tax on all earlier distributions.⁷

Required Minimum Distributions Cap the Deferral

If your variable annuity is inside a qualified plan, deferral does not last forever. You must begin taking required minimum distributions at age 73.⁸ The rule covers traditional IRAs, 401(k)s, 403(b)s, and 457(b) plans.

The annual amount is your prior-year December 31 balance divided by a life expectancy factor from IRS tables in Publication 590-B. Falling short brings an excise tax of 25% on the amount you should have withdrawn, dropping to 10% if you fix the shortfall within two years.⁸

Non-qualified variable annuities are not subject to RMD rules.

An Extra 3.8% for High Earners on Non-Qualified Withdrawals

Higher-income owners of non-qualified annuities face a second layer of tax. The 3.8% net investment income tax applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly, and the taxable earnings portion of a non-qualified distribution counts as net investment income.⁹

Distributions from qualified plans — 401(k)s, 403(b)s, IRAs, and 457(b)s — are not subject to the NIIT.⁹ The income thresholds are not indexed for inflation.

Switching Contracts Without Losing Deferral

If you want to move to a different annuity for lower fees or better investment options, a Section 1035 exchange lets you swap one annuity contract for another (or for a qualified long-term care insurance contract) with no gain recognized.¹⁰

Two things have to be right. The funds must move directly from the old insurer to the new one; if the money passes through your hands, the IRS treats it as a withdrawal and a new purchase, and any gain becomes taxable. The exchange also carries your original cost basis over to the new contract, so accumulated earnings remain earnings for tax purposes.¹⁰ You can exchange a life insurance policy for an annuity tax-free, but not the reverse.

What Beneficiaries Pay

Unlike inherited stocks or real estate, annuities do not get a step-up in cost basis at death. A beneficiary owes ordinary income tax on the portion of the death benefit that exceeds the owner’s original investment.³

How quickly the money has to come out depends on the beneficiary:

A surviving spouse can typically continue the contract in their own name, deferring tax until they take withdrawals. If the annuity was already paying out, the spouse figures the taxable and tax-free portions using the same method that applied to the original owner.³
For deaths in 2020 or later, most non-spouse designated beneficiaries must empty the inherited account by the end of the 10th year after the year of death.¹¹
Eligible designated beneficiaries — a minor child, a disabled or chronically ill person, or someone no more than 10 years younger than the deceased — may stretch distributions over their own life expectancy instead.¹¹

If the death benefit is included in the owner’s taxable estate, the beneficiary may be able to claim an income tax deduction for the estate taxes attributable to that income.³

1
Investor.gov U.S. Securities and Exchange Commission. Variable Annuities
2
U.S. Securities and Exchange Commission. Variable Annuities: What You Should Know
3
Internal Revenue Service. Publication 575, Pension and Annuity Income
4
IRS.gov. Rev. Proc. 2008-24
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
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
9
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
10
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
11
Internal Revenue Service. Retirement Topics – Beneficiary