Do Annuities Grow Tax Deferred and How Are They Taxed?

Annuities are taxed on a deferred basis: earnings inside the contract are not taxed while they accumulate, and the IRS collects tax only when you take money out or begin receiving payments. What you pay then depends on three things — whether the annuity was funded with pre-tax or after-tax dollars, how old you are when money comes out, and whether you take a withdrawal or convert the contract into a stream of payments. How annuities are taxed is best understood by working through each of those pieces in order.

Why Nothing Is Taxed While the Money Stays Inside

During the accumulation phase, interest, dividends, and investment gains stay in the contract and keep compounding. The IRS does not require insurance companies to report those earnings on Form 1099-INT or 1099-DIV while the money remains inside the annuity. No annual reporting means no annual tax bill; the gains are treated as unrealized until a distribution occurs.¹ Once you touch the money, the deferral ends and the tax rules below take over.

Qualified Versus Non-Qualified: The Split That Drives Everything

The single biggest factor in your tax bill is where the money came from.

Qualified Annuities

A qualified annuity is funded with pre-tax dollars, typically through a rollover from a 401(k), traditional IRA, or another employer plan. Because those contributions were never taxed, the entire balance — original contributions and all growth — is taxed as ordinary income when distributions begin.² There is no tax-free portion to recover.

Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax money. Because you already paid tax on the dollars you put in, only the growth is taxed on the way out. Your original investment, called your cost basis, comes back to you tax-free.¹ How that split actually plays out depends on whether you take a withdrawal or annuitize.

How Withdrawals Are Taxed

Non-Qualified Withdrawals: Earnings Come Out First

For non-qualified annuities, the IRS treats every dollar you withdraw as coming from earnings until all the earnings are gone. Only then do withdrawals start drawing from your after-tax investment. The statute allocates distributions “to income on the contract” first and “to the investment in the contract” second.³ This ordering rule applies to contracts entered into after August 13, 1982.⁴

Say you bought an annuity with $100,000 of after-tax money and it has grown to $150,000. The first $50,000 you withdraw is fully taxable as ordinary income. Only after that $50,000 is exhausted do withdrawals come out of your $100,000 cost basis, and those dollars aren’t taxed again.

Qualified Withdrawals: Everything Is Taxable

Since qualified annuities hold money that was never taxed, the entire withdrawal — principal and growth — is ordinary income. There is no cost basis to recover.² Every dollar that comes out is added to your taxable income for the year.

Annuitized Payments and the Exclusion Ratio

If you convert a non-qualified annuity into a stream of periodic payments, the tax picture changes. Rather than pulling out all the earnings first, the IRS lets you spread the tax-free return of your cost basis across every payment using an exclusion ratio. The ratio equals your investment in the contract divided by the total expected return over the payout period.³

If you invested $120,000 and the expected return over your lifetime is $200,000, your exclusion ratio is 60%. Sixty percent of each payment comes back tax-free; the remaining 40% is taxed as ordinary income. Once you have fully recovered your cost basis, every later payment is fully taxable.¹ The IRS provides two methods for the calculation, the Simplified Method and the General Rule, with most private annuities using the Simplified Method based on your age at the annuity starting date.

The 10% Early Withdrawal Penalty

Taking taxable amounts from an annuity before age 59½ triggers an additional 10% tax on top of the regular income tax you owe. For non-qualified annuities the penalty comes from Section 72(q) of the Internal Revenue Code; for qualified annuities held in IRAs or employer plans, Section 72(t) imposes the same 10% charge.³ Combined with ordinary income tax rates that run from 10% to 37% for 2026, an early withdrawal can cost close to half the distribution.⁵

Section 72(q)(2) lists exceptions that waive the 10% penalty even before age 59½:

Distributions made after the owner’s death.
Distributions to an owner who becomes totally and permanently disabled.
A series of substantially equal periodic payments based on life expectancy, taken at least once a year. Changing the schedule before five years have passed or before you reach 59½, whichever is later, triggers retroactive penalties on all prior distributions.
Payments from an immediate annuity that begins payouts within one year of purchase.
Amounts allocable to investments made in the contract before August 14, 1982.

These exceptions waive the 10% penalty, not the income tax. You still owe ordinary income tax on the taxable portion of every distribution.³

Required Minimum Distributions on Qualified Annuities

Qualified annuities held inside IRAs or employer plans are subject to required minimum distributions beginning at age 73.⁶ The annual amount is your prior December 31 balance divided by a life expectancy factor from the tables in IRS Publication 590-B. Missing an RMD or taking less than required triggers a 25% excise tax on the shortfall; correcting the mistake within two years reduces the penalty to 10%.⁷

Non-qualified annuities are not subject to RMD rules during the owner’s lifetime. Distribution rules do apply to beneficiaries once the owner dies.

Switching Contracts Without a Tax Bill: 1035 Exchanges

If you want out of a particular annuity, you don’t have to surrender it and pay tax on the gains. Section 1035 of the Internal Revenue Code lets you exchange one annuity contract for another with no gain or loss recognized. The new contract inherits the cost basis and tax-deferred status of the old one.⁸ A life insurance policy may be exchanged for an annuity, but not the other way around.

Two conditions matter. The exchange must involve the same owner, and the money has to move directly between insurance companies; if the funds touch your hands, the IRS treats it as a withdrawal followed by a new purchase, and the earnings are taxed. For partial exchanges, surrendering or withdrawing from either contract within 24 months of the exchange can cause the IRS to collapse the transaction and tax it under the ordinary withdrawal rules.⁹

Taxes When the Owner Dies

Annuities do not receive a step-up in basis at death. That is one of the sharpest differences between annuities and other inherited assets. Inherited stock resets to fair market value at the date of death, wiping out unrealized gains. Annuities get no such reset. The beneficiary steps into the original owner’s cost basis, and the growth portion is taxed as ordinary income when distributed.

For a non-qualified annuity with a $100,000 cost basis and a $175,000 value at death, the beneficiary owes ordinary income tax on the $75,000 of growth. If the beneficiary takes a lump sum, the taxable amount is the excess over the owner’s cost basis.¹ For a qualified annuity, the entire distribution is taxable to the beneficiary, exactly as it would have been to the original owner.

The 10% early withdrawal penalty does not apply to distributions made after the owner’s death, whatever the beneficiary’s age.³ Income tax still applies, and a large inherited annuity taken in a single year can push the beneficiary into a higher bracket. When the contract and the applicable rules permit, spreading distributions across multiple years reduces the total tax paid.

State Income Tax

Federal rules apply uniformly, but state treatment of annuity distributions varies. Some states exempt retirement income entirely, some provide partial exemptions based on age or income, some tax distributions as the federal government does, and a handful have no income tax at all. If you plan to retire in a different state than where you live now, check the state’s rules before starting distributions; on a sizable annuity, the difference between a state that taxes retirement income and one that doesn’t can run into thousands of dollars a year.

1
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
2
Internal Revenue Service. Topic No. 410, Pensions and Annuities
3
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
The Tax Adviser. Deferring Income Using Annuities
5
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
6
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
7
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
8
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
9
Internal Revenue Service. Notice 2003-51 – Treatment of Certain Exchanges of Insurance Policies