How annuities are taxed comes down to one question: was the money that funded the contract already taxed before it went in? If it was not — the case for annuities held inside 401(k)s, traditional IRAs, and similar plans — every dollar you take out is ordinary income. If it was — the case for annuities you bought with your own after-tax savings — only the earnings are taxable, and the IRS uses different rules to separate earnings from principal depending on whether you take a withdrawal or convert the contract into a stream of income payments.
Qualified Annuities: Every Dollar Is Taxable
A qualified annuity sits inside a tax-advantaged retirement account. Contributions went in before tax, the earnings grew untaxed, and nothing in the contract has ever been touched by the IRS. When distributions start, IRC Section 72 treats the full amount as ordinary income at whatever bracket applies to you that year.1Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
Two timing rules matter. Required Minimum Distributions generally begin at age 73. Miss one, or take less than required, and the IRS charges a 25% excise tax on the shortfall, dropping to 10% if you correct the mistake within two years.2Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs) On the front end, pulling money out before age 59½ triggers a 10% additional tax on top of regular income tax, and because the entire withdrawal is taxable, the penalty applies to the whole thing. Exceptions include death, total and permanent disability, a series of substantially equal periodic payments, separation from service during or after the year you turn 55, and certain medical or disaster-related withdrawals.3Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
The Roth Exception
Roth-funded annuities flip the picture. Money went in after tax, so qualified distributions come out entirely tax-free. A distribution qualifies once at least five tax years have passed since your first Roth contribution and you are 59½ or older, disabled, or deceased.4Internal Revenue Service. Retirement Topics – Designated Roth Account If those conditions are not met, the earnings portion is taxable and can face the 10% penalty. Your contributions always come out tax- and penalty-free because you already paid tax on them.
Non-Qualified Annuities: Only the Earnings Are Taxed
A non-qualified annuity is one you bought outside any employer plan or IRA with money you had already paid tax on. That original investment is your cost basis, and the IRS will not tax it again. What it will tax is the growth that accumulated inside the contract, and always at ordinary income rates rather than the lower long-term capital gains rates that apply to stocks or funds held in a taxable account. That rate difference is part of the trade-off for years of tax-deferred growth.
Higher-income taxpayers can face an extra layer. The taxable portion of a non-qualified annuity distribution counts as net investment income under IRC Section 1411, which can trigger a 3.8% surtax when modified adjusted gross income exceeds $250,000 for joint filers, $200,000 for single filers, or $125,000 for married filing separately.5Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax Those thresholds are not indexed for inflation. Qualified plan distributions are exempt from this surtax because they are treated as pension and annuity income rather than investment income.6Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Partial Withdrawals: Earnings Come Out First
Take a partial withdrawal from a non-qualified annuity and the IRS assumes you are pulling out gain before principal. Under IRC Section 72(e), every dollar is treated as taxable earnings until all the accumulated growth in the contract has been withdrawn. Only after that does your tax-free cost basis start coming out.1Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Practitioners call this LIFO ordering: last in, first out.
An example. A non-qualified annuity is worth $150,000, with a $100,000 cost basis and $50,000 in accumulated earnings. Withdraw $20,000 and the full $20,000 is ordinary income, because it all comes from the earnings layer. You would need to pull the entire $50,000 of gain before any subsequent withdrawal reached your tax-free principal.
Withdrawals before age 59½ carry a 10% additional tax under IRC Section 72(q), and the exceptions are narrower than the ones for qualified plans. The penalty does not apply after age 59½, after the owner’s death, on disability, when the owner sets up substantially equal periodic payments over life expectancy, to amounts from an immediate annuity, or to investment attributable to contributions made before August 14, 1982.7Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (q) The age-55 separation-from-service exception, the first-time homebuyer exception, and the higher-education exception that apply to IRAs and employer plans do not apply to non-qualified annuities. That mismatch catches people who assume the qualified plan rules carry over.
Annuitized Payments: The Exclusion Ratio
Converting a non-qualified annuity into a stream of lifetime income payments switches you to a different and generally friendlier method. Under IRC Section 72(b), each payment is split into a tax-free return of principal and a taxable earnings portion using a fixed percentage that stays constant for the life of the payout.8Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (b)
The formula divides your total investment in the contract by the expected return, where expected return is the annual payment amount multiplied by a life-expectancy factor from actuarial tables the IRS publishes in Publication 939.9Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities Suppose you invested $200,000 and the tables project a total payout of $400,000 over your lifetime. Your exclusion ratio is 50%. Half of every payment is tax-free and half is taxable as ordinary income. Compared with LIFO, this spreads the tax burden evenly across the payout rather than front-loading all the taxable income into the early years.
After the Basis Is Fully Recovered
The exclusion ratio does not run forever. Once the tax-free portions of your payments add up to your original cost basis, you have recovered your full investment, and every payment after that is 100% taxable.10eCFR. 26 CFR 1.72-4 – Exclusion Ratio If the tables projected 20 years and you are still collecting in year 25, those extra payments come with no exclusion.
If the Annuitant Dies Early
The reverse scenario carries a partial offset. If the annuitant dies before recovering the entire cost basis, IRC Section 72(b)(3) allows the unrecovered amount as a deduction on the final tax return, and treats it as attributable to a trade or business, which can produce a net operating loss on that return.11Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (b)(3)
Death Benefits: No Step-Up in Basis
Annuities do not get the stepped-up basis that stocks and real estate receive at death. When the owner of a deferred annuity dies before payments begin, the gain inside the contract is income in respect of a decedent under IRC Section 691. The beneficiary owes ordinary income tax on the amount by which the death benefit exceeds the original cost basis, whether they take the money as a lump sum or as periodic payments.12Internal Revenue Service. Revenue Ruling 2005-30
For non-qualified annuities the taxable amount is the death benefit minus the decedent’s investment in the contract. For qualified annuities the entire distribution is generally taxable, because the contributions were never taxed in the first place. A beneficiary receiving a joint and survivor annuity calculates the tax-free portion using the same exclusion ratio the original annuitant used.13Internal Revenue Service. Publication 575 – Pension and Annuity Income
Giving an Annuity Away Triggers Tax
Gifting a non-qualified annuity is not like gifting a share of stock. Under IRC Section 72(e)(4)(C), transferring the contract without full and adequate consideration is a taxable event for the person making the transfer. The original owner must recognize ordinary income equal to the difference between the contract’s cash surrender value and their cost basis, the same gain a withdrawal would have produced. The recipient’s cost basis then includes the amount the transferor was taxed on, so the earnings are not taxed twice.14Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (e)(4)(C)
Transfers between spouses, or to a former spouse as part of a divorce, are the significant exception and do not trigger this tax. The receiving spouse steps into the original owner’s position, carrying over the same cost basis and deferred gain. Outside of that, gifting an annuity accelerates the exact tax bill the owner was deferring, and the income tax hit can easily dwarf any gift tax the transfer was meant to sidestep.
1035 Exchanges Preserve the Deferral
Swapping one annuity for another does not have to be taxable. Under IRC Section 1035, you can exchange an annuity contract for a new annuity contract or a qualified long-term care insurance policy without recognizing gain or loss. Life insurance and endowment contracts can be exchanged into annuities the same way. Exchanges only flow one direction on the product spectrum: life insurance to annuity is allowed, annuity back to life insurance is not.15Office of the Law Revision Counsel. 26 U.S.C. 1035 – Certain Exchanges of Insurance Policies
Partial exchanges are also permitted. Under Revenue Procedure 2011-38, moving part of an existing annuity’s cash value into a new contract qualifies for tax-free treatment as long as no withdrawals come out of either contract during the 180 days after the transfer. Violate that window and the IRS can look at the substance of the transaction and reclassify part or all of it as a taxable distribution.16Internal Revenue Service. Revenue Procedure 2011-38 The 180-day restriction does not apply if the money goes into an immediate annuity paying out over 10 years or more, or over the annuitant’s lifetime.
A 1035 exchange carries over the original contract’s cost basis and holding period. You are not resetting the tax clock, just moving the same tax characteristics into a new wrapper. Surrender charge schedules on the new contract, however, start fresh.
The Same-Year, Same-Insurer Aggregation Rule
One anti-abuse rule catches a common workaround. Under IRC Section 72(e)(12), all non-qualified annuity contracts issued by the same insurance company to the same owner in the same calendar year are treated as a single contract for tax purposes.17Office of the Law Revision Counsel. 26 U.S.C. 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section (e)(12) Without this rule, an owner could split money across several small contracts, withdraw only from the one with the lowest earnings, and dodge the LIFO ordering. Aggregation pools the cost basis and gain across every contract from that insurer in that year.
Qualified annuities inside employer plans or IRAs are outside this rule, and contracts from different insurers are never aggregated. Buying from two different companies in the same year keeps each contract on its own tax accounting, and buying from the same insurer in different calendar years does the same.