How Are Annuities Given Favorable Tax Treatment?

Annuities are taxed under a set of rules that let earnings grow inside the contract without an annual tax bill, then tax those earnings as ordinary income when you take money out. How much of each withdrawal is taxable depends on whether the annuity is qualified (held inside a retirement account funded with pre-tax dollars) or non-qualified (bought with money you’ve already paid tax on), and on whether you take partial withdrawals or convert the contract into a stream of payments. Withdrawals before age 59½ carry an extra 10% tax on top of the income tax.

Qualified vs. Non-Qualified Annuities

The first thing that determines your tax treatment is the type of contract you own.

A qualified annuity sits inside a tax-advantaged retirement account such as an IRA, 401(k), or 403(b). Contributions typically went in pre-tax, so no tax has been paid on any of the money in the contract.¹ When you withdraw, the full amount — contributions and earnings — is taxable as ordinary income.²

A non-qualified annuity is bought with after-tax money. You get no deduction going in, but only the earnings portion of each distribution is taxable. Your original after-tax contributions come back to you tax-free.³ The split between the two is where the more detailed rules come in.

Tax-Deferred Growth Inside the Contract

Whether the annuity is qualified or non-qualified, interest and investment gains credited to the contract are not taxed each year. The full balance keeps compounding until you take a distribution.² That’s the core tax advantage over a regular brokerage account, where dividends and realized gains generate a tax bill every year and reduce the amount available to reinvest.

There is a trade-off. When you eventually withdraw the earnings, they are taxed at your ordinary income tax rate, not at the lower long-term capital gains rates that apply to investments held outside an annuity.² Whether years of tax-deferred compounding come out ahead depends on your time horizon, your tax bracket in retirement, and the contract’s fees.

One boundary worth knowing: this deferral is available only to individual owners. If a corporation, trust (other than one holding the contract as agent for an individual), or other non-natural entity owns the annuity, the IRS strips away its tax-deferred status, and income earned inside the contract is taxed to the entity each year even without a withdrawal.³ Contracts held inside qualified retirement plans, contracts acquired by an estate, and immediate annuities are exceptions.

How Withdrawals Are Taxed

Once you take money out, two different formulas apply depending on how you take it.

Partial Withdrawals: Earnings Come Out First

If you take a partial withdrawal from a non-qualified annuity before converting it to a payment stream, the IRS uses last-in, first-out treatment. Earnings are considered to come out first, so those dollars are fully taxable as ordinary income until all accumulated earnings have been withdrawn.³

Say your non-qualified contract has a $100,000 cost basis and has grown to $150,000. Of that, $50,000 is earnings. Withdraw $30,000, and the entire $30,000 is taxable. You don’t start pulling out tax-free principal until you’ve withdrawn more than $50,000. After the full $100,000 basis has come back to you, any further withdrawals are again fully taxable.

Annuitized Payments: The Exclusion Ratio

If you annuitize a non-qualified contract — convert it into a scheduled stream of payments — the tax split is calculated differently. Each payment is divided into a tax-free return of your investment and a taxable earnings portion, using an exclusion ratio equal to your after-tax investment in the contract divided by the expected total return based on your life expectancy at the annuity starting date.³

If you invested $100,000 and the expected total payout is $200,000, your exclusion ratio is 50%. Half of every payment is tax-free, and half is taxed as ordinary income.⁴ This continues until you’ve recovered your full investment through those tax-free portions. If you outlive your life expectancy, every payment after that point is fully taxable.³

The practical difference: annuitizing spreads the taxable portion evenly across each payment; partial withdrawals front-load it.

The 10% Early Withdrawal Penalty

Take a taxable distribution before age 59½ and the IRS adds a 10% tax on top of the regular income tax owed on the earnings.³ The same penalty applies to early distributions from qualified retirement plans that hold annuities.⁵

Several exceptions eliminate it:

Distributions taken after age 59½.
Distributions made to a beneficiary after the contract holder’s death.
Distributions attributable to disability, defined as being unable to engage in substantial work because of a condition expected to result in death or last indefinitely.
Substantially equal periodic payments made at least annually over your life expectancy (or the joint life expectancies of you and a beneficiary), continued for at least five years or until you reach 59½, whichever comes later.
Payments from an immediate annuity — a single-premium contract that begins payments within one year of purchase.

Separately, the insurance company may charge its own surrender fee on early withdrawals. That’s a contract cost, not an IRS penalty.

Required Minimum Distributions

Annuities held inside a traditional IRA, 401(k), or similar qualified account are subject to required minimum distributions starting at age 73. If you were born in 1960 or later, the starting age becomes 75 in 2033.⁶ Non-qualified annuities have no RMD requirement during the owner’s lifetime, and neither do annuities held inside a Roth IRA.

Missing an RMD, or taking less than the required amount, triggers a 25% excise tax on the shortfall. Correct the shortfall within two years and that drops to 10%.⁷

Taxes on an Inherited Annuity

Annuities do not get the stepped-up cost basis that many other inherited assets receive. A beneficiary inherits the original owner’s basis, and the accumulated earnings remain taxable as ordinary income when distributed, whether the beneficiary takes a lump sum or spreads payments over time.³

A surviving spouse has the most flexibility with a non-qualified annuity: the spouse can step into the owner’s role and continue tax-deferred growth as if the contract had always been theirs, with no immediate distribution required.³

A non-spouse beneficiary of a non-qualified annuity generally has to empty the contract within five years of the owner’s death. A designated individual beneficiary can instead stretch distributions over their own life expectancy if payments begin within one year of the owner’s death.³ For qualified annuities inside retirement accounts, the SECURE Act’s 10-year rule applies: most non-spouse designated beneficiaries must empty the inherited account by the end of the tenth year after the year of the owner’s death, with longer payout periods available to certain eligible categories such as minor children and disabled individuals.⁸

Because inherited annuity earnings hit as ordinary income, a lump sum can push a beneficiary into a higher tax bracket for the year. Spreading distributions across the available window softens that.

Swapping Annuities Without Tax: Section 1035

If you want to move to a different annuity — for better investment options, lower fees, or a feature your current contract lacks — federal law lets you exchange one annuity for another without triggering a taxable event. You can also exchange an annuity for a qualified long-term care insurance contract. Your original cost basis carries over.⁹

The transfer must go directly between insurance companies. If you take personal possession of the funds along the way, the IRS treats the transaction as a taxable withdrawal. Partial 1035 exchanges are allowed, but taking a withdrawal from either contract within 180 days of a partial exchange can cause the IRS to recharacterize the exchange as a taxable distribution.¹⁰

1
Office of the Law Revision Counsel. 26 USC 403 – Taxation of Employee Annuities
2
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
eCFR. 26 CFR 1.72-4 – Exclusion Ratio
5
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
6
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
7
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
8
Internal Revenue Service. Retirement Topics – Beneficiary
9
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
10
Internal Revenue Service. Revenue Procedure 2011-38 – Section 1035 Partial Exchanges