Annuities are taxed when distributed as ordinary income, and how much of each payment is taxable depends on whether you funded the contract with pre-tax or after-tax money. Pull money from a qualified annuity funded through a 401(k), traditional IRA, or similar plan and every dollar is taxable, because you never paid tax on the contributions. Pull money from a non-qualified annuity funded with money you already paid tax on and only the earnings are taxable; your original investment comes back to you tax-free.1Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income Layered on top are a possible 10% penalty for withdrawing before age 59½, a 3.8% surtax at higher income levels, and mandatory withholding at the time of payment.
Qualified and Non-Qualified Annuities Are Taxed Differently
Qualified annuities live inside a retirement account funded with pre-tax dollars. Because no tax was ever paid on the money going in, the entire distribution comes out as ordinary income at your current federal rate.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts There is no tax-free portion to recover.
Non-qualified annuities are bought with money you’ve already been taxed on, like savings or brokerage proceeds. The IRS taxes only the earnings and lets you recover your original investment tax-free. How that split gets calculated depends on whether you take one-off withdrawals or convert the contract into a stream of payments.
Partial Withdrawals Come Out of Earnings First
If you take a partial withdrawal from a non-qualified annuity without annuitizing it, the IRS treats earnings as coming out first. This last-in, first-out ordering means every dollar you withdraw is fully taxable until the accumulated gains are gone. Only after that do you start pulling tax-free principal.3Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income – Section: Withdrawals
The practical effect surprises many owners. Someone who put $100,000 into a non-qualified annuity that grew to $160,000 doesn’t get a mostly tax-free $20,000 withdrawal. The entire $20,000 comes out of the $60,000 in gains and is fully taxable. Principal only starts flowing back tax-free once every cent of earnings has been withdrawn.
Annuitized Payments and the Exclusion Ratio
Converting a non-qualified contract into a lifetime stream of payments changes the math. The IRS lets you spread the tax-free return of your investment across every payment using the exclusion ratio.4Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
The formula divides your investment in the contract by the expected total return over your life expectancy, using IRS life expectancy tables. If you put in $100,000 and the expected payout is $200,000, half of each payment is a tax-free return of principal and half is taxable. That ratio holds until you’ve recovered your full investment. After that point, every remaining payment is fully taxable. For contracts with a starting date after 1986, you cannot exclude more than your net cost, so if you outlive the tables, the extra years of payments are entirely taxable.
Qualified annuitized payments don’t get an exclusion ratio because there was no after-tax investment to recover. Every payment is fully taxable from the first check.
The 10% Early Withdrawal Penalty
Taking taxable money out of an annuity before age 59½ adds a 10% penalty on top of ordinary income tax. The penalty applies only to the portion included in your gross income, not to any tax-free return of principal.5Internal Revenue Service. Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs For qualified annuities in IRAs, the penalty comes from Section 72(t). For non-qualified contracts, the parallel provision is Section 72(q), which imposes the same rate with its own list of exceptions.6Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: 72(q)
Both provisions waive the penalty in several situations:
- Distributions to a beneficiary after the owner’s death.7Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
- Total and permanent disability of the owner; the distribution stays taxable but avoids the penalty.8Internal Revenue Service. Retirement Topics – Disability
- A schedule of substantially equal periodic payments based on life expectancy.
- Payments from an immediate annuity, for non-qualified contracts under Section 72(q).9Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: 72(q)(2)(I)
Qualified annuities in IRAs and employer plans carry extra exceptions that non-qualified contracts don’t, such as certain medical expenses and first-time home purchases. Which provision governs your contract determines which exceptions you can use.
Substantially Equal Periodic Payments as a Workaround
If you need income before 59½ and don’t fit an exception, you can set up a series of substantially equal periodic payments based on your life expectancy. The IRS allows three calculation methods, and both qualified and non-qualified contracts can use this approach.10Internal Revenue Service. Substantially Equal Periodic Payments
The lock-in is strict. Once payments start you cannot change the amount or take extra withdrawals. The schedule has to run until the later of five years from the first payment or the date you turn 59½. Modifying it early for any reason other than death or disability triggers a retroactive 10% penalty on every distribution taken since the payments began, plus interest.
The 3.8% Net Investment Income Tax
The taxable portion of a non-qualified annuity distribution can also trigger the Net Investment Income Tax. This 3.8% surtax applies when modified adjusted gross income exceeds $200,000 for a single filer or $250,000 for a married couple filing jointly, and it hits the lesser of your net investment income or the amount by which your income exceeds the threshold. The statute lists annuity income as investment income for this purpose.11Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
The thresholds aren’t indexed for inflation, so they’ve held steady since 2013. A large lump-sum distribution can push you over the line even if your regular income normally sits below it. Qualified annuity distributions from traditional IRAs and employer plans are generally excluded from net investment income, so the surtax is primarily a non-qualified issue.
Required Minimum Distributions on Qualified Annuities
Qualified annuities held in traditional IRAs, SEP IRAs, SIMPLE IRAs, and most employer plans are subject to required minimum distributions. You have to start taking annual withdrawals by April 1 of the year after you turn 73.12Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs If you’re still working and don’t own more than 5% of the business sponsoring your plan, you can wait to take distributions from that employer’s plan until you actually retire.
Missing an RMD is expensive. The excise tax on the shortfall is 25% of what you should have withdrawn, dropping to 10% if you correct the mistake within two years by taking the missed distribution and filing Form 5329. Non-qualified annuities are not subject to RMDs during the owner’s lifetime.
Withholding on Distributions
Federal income tax is generally withheld from an annuity payment before it reaches you. Regular periodic payments are withheld like wages based on the W-4P you file with the payer. One-time or irregular withdrawals that aren’t eligible rollovers default to 10% withholding. Eligible rollover distributions from qualified plans carry a mandatory 20% that you can only avoid by arranging a direct rollover to another qualified plan or IRA.1Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
Withholding is a prepayment, not a final bill. On a large distribution, the default 10% or 20% usually falls short of what you’ll actually owe once you add the early withdrawal penalty and any 3.8% surtax. Requesting additional withholding on Form W-4R avoids a surprise at filing time.
Tax on Inherited Annuities
Annuities do not get a step-up in basis at death. The beneficiary inherits the original owner’s cost basis and owes income tax on all the accumulated earnings.1Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income The distribution timeline depends on the contract type and the beneficiary’s relationship to the deceased.
For a non-qualified annuity under Section 72(s), if the owner dies before the annuity starting date the entire interest generally has to be distributed within five years. A beneficiary who elects to take payments over their own life expectancy and starts within one year of the death can stretch the payout instead. A surviving spouse can continue the contract as if it were their own and delay distributions indefinitely.13Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts – Section: 72(s)(3)
For qualified annuities inside IRAs and employer plans, the SECURE Act reset the rules for deaths after 2019. Most non-spouse beneficiaries now have to empty the account by the end of the tenth year after the owner’s death.14Internal Revenue Service. Retirement Topics – Beneficiary A narrow group of “eligible designated beneficiaries” can still use the lifetime stretch: a surviving spouse, a minor child of the deceased (until reaching the age of majority, at which point the 10-year rule takes over), disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased. Everyone else, including most adult children, falls under the 10-year rule. A surviving spouse who inherits a qualified annuity in an IRA can also roll it into their own IRA and reset the distribution timeline.
Whether the inherited annuity is qualified or non-qualified, a lump-sum payout concentrates all the taxable gains into a single year and often pushes the beneficiary into a higher bracket. Spreading distributions across the available window usually produces a better result.
1035 Exchanges Let You Move Between Annuities Tax-Free
Moving from one annuity to another doesn’t have to trigger tax. A 1035 exchange transfers the contract’s value directly to a new annuity contract with no gain or loss recognized.15Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies You can also exchange an annuity for a qualified long-term care insurance contract tax-free, though you cannot go the other direction into a life insurance policy.
The owner has to be the same person on both contracts, and the transfer has to move directly from insurer to insurer.16eCFR. 26 CFR 1.1035-1 – Certain Exchanges of Insurance Policies If the check comes to you and you then buy the new contract, the IRS treats the original payment as a taxable distribution. Your cost basis carries over to the new contract, so a 1035 exchange defers tax rather than eliminating it.
Surrender Charges Are Not a Tax
One thing worth separating from the tax picture: the surrender charges most deferred annuities impose during the early years of the contract are contractual fees charged by the insurance company, not federal penalties. A typical schedule starts around 7% in the first year and declines by roughly a percentage point each year until it disappears after seven or eight years, and many contracts allow a 10% annual free withdrawal. A withdrawal before 59½ during the surrender period can stack the surrender charge, ordinary income tax, and the 10% penalty on the same dollar of earnings.