How Are Immediate Annuities Taxed: Exclusion Ratio, RMDs, and Penalties

An immediate annuity is taxed by splitting each payment into two parts: a tax-free return of the money you put in and a taxable share of the earnings. How that split is calculated depends on where the purchase money came from. If you bought the contract with after-tax savings, the IRS uses a formula called the exclusion ratio to decide how much of each check escapes tax. If you funded it with pre-tax retirement dollars from a traditional IRA or 401(k), there is nothing to exclude, and every dollar is ordinary income.¹

Non-Qualified Annuities: The Exclusion Ratio

A non-qualified immediate annuity is one you bought with money you had already paid income tax on, such as savings or brokerage proceeds. Because the premium was already taxed, the IRS does not tax it a second time when it comes back to you. Each payment carries a fixed proportion of tax-free principal and taxable earnings, and that proportion stays the same for the life of the contract.²

The tax-free share is not permanent. Once you have received back every dollar of your original premium through the exclusion, future payments become fully taxable as ordinary income.³ If you outlive your statistical life expectancy, the checks keep coming but the tax break ends.

How to Calculate the Exclusion Ratio

The formula is your investment in the contract divided by your expected return. The investment is the premium you paid. The expected return is the total you are statistically expected to receive over the life of the annuity.⁴

How you figure expected return depends on the payout:

For a life annuity, multiply your annual payment by the life expectancy factor the IRS assigns to your age. The factors come from the actuarial tables in Publication 939. For annuities starting after June 1986, the unisex Tables V through VIII apply.⁵
For a period-certain annuity, multiply the payment by the guaranteed number of payments. A 10-year certain contract paying $600 a month has an expected return of $72,000.
For a joint and survivor annuity, use the joint life expectancy factor from the appropriate IRS table based on both annuitants’ ages.

A Worked Example

Suppose you are 65 and pay $100,000 for a non-qualified immediate annuity that pays $500 a month for life. The Table V life expectancy factor at age 65 is 20.0, so your expected return is $120,000 ($500 times 240 monthly payments).

Your exclusion ratio is 83.33%, or $100,000 divided by $120,000. That makes $416.65 of each $500 check tax-free, and the remaining $83.35 taxable as ordinary income. After 240 payments, you will have recovered the full $100,000. From payment 241 onward, the entire $500 is taxable.³

Qualified Annuities: Every Dollar Is Taxable

A qualified immediate annuity is funded with pre-tax retirement money, usually through a rollover from a traditional IRA, 401(k), or 403(b). No income tax was ever paid on those contributions or on the growth, so every dollar coming out is taxable. The exclusion ratio does not apply, because there is no after-tax cost basis to recover.¹

Each payment is taxed as ordinary income at your marginal federal rate. If you are in the 22% bracket, $1,000 of monthly annuity income means roughly $220 of federal tax on that payment before deductions and credits.

There is a narrow exception. If your retirement account held after-tax (non-deductible) contributions, that portion carries a cost basis. This can happen with non-deductible contributions to a traditional IRA. The exclusion ratio then applies only to the slice of the annuity attributable to those after-tax dollars; the rest is fully taxable.

Annuities Funded With Roth Money

An immediate annuity bought with a Roth IRA rollover is generally tax-free, provided you are at least 59½ and at least five years have passed since your first Roth IRA contribution. Roth contributions were made with after-tax dollars and the growth has already satisfied the qualified distribution rules, so neither the return of principal nor the earnings triggers federal income tax.

The 10% Early Withdrawal Penalty Does Not Apply

Federal tax law imposes a 10% penalty on taxable distributions from annuity contracts taken before age 59½, but immediate annuities get a specific carve-out. IRC 72(q)(2)(I) exempts payments from an immediate annuity contract from the penalty altogether.⁴ A separate exemption under 72(q)(2)(D) covers a series of substantially equal periodic payments made over your life expectancy, which also describes how most immediate annuities are structured.

A 55-year-old who buys a single-premium immediate annuity and starts collecting monthly payments will not owe the 10% penalty, even though they are well under 59½. The penalty is aimed at early cash-outs from deferred annuities, not at people who have committed to a lifetime income stream.

The 3.8% Net Investment Income Surtax

The taxable portion of non-qualified annuity income counts as net investment income under IRC 1411.⁶ The 3.8% surtax applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly). If your annuity income pushes you past those thresholds, you will owe an extra 3.8% on the lesser of your net investment income or the amount over the threshold.

Distributions from qualified retirement plan annuities (those funded by traditional IRAs, 401(k)s, and 403(b)s) are excluded from net investment income entirely, so the surtax does not reach them.⁷

If You Die Before Recovering Your Investment

If you die before receiving back your full premium through the exclusion, the unrecovered amount does not disappear. For annuities with a starting date after 1986, the remaining cost basis is allowed as an itemized deduction on your final return.⁴

Using the earlier example: if you invested $100,000, recovered $9,600 a year through the exclusion, and died after eight years, you would have received $76,800 tax-free. The remaining $23,200 is deductible on your final return.³ It is treated as if connected to a trade or business for net operating loss purposes, which lets it offset other income rather than being limited by the usual itemized deduction floors.

How Beneficiaries Are Taxed

Many immediate annuities include a guaranteed period or refund feature that continues payments to a beneficiary. For a non-qualified contract with remaining cost basis, the beneficiary keeps using the original exclusion ratio until the full investment is recovered; after that, every payment is fully taxable. If the contract has no survivor feature and payments simply stop, the unrecovered basis deduction described above applies instead.⁴

For a qualified annuity, beneficiary payments stay 100% taxable as ordinary income. There is no cost basis to recover, so every dollar the beneficiary receives is included in their gross income.

Required Minimum Distributions for Qualified Annuities

An immediate annuity bought with pre-tax retirement funds is subject to required minimum distribution rules. Under the SECURE 2.0 Act, RMDs must begin by age 73 for individuals born between 1951 and 1959, and by age 75 for those born in 1960 or later.⁸

The annuity payments themselves count toward your RMD obligation. The insurance company sets the fair market value of the annuity at year-end, and the annual income is compared against the RMD calculated from that value. If payments exceed the RMD attributable to the annuity, the excess can even help satisfy RMD requirements for other retirement accounts you hold.

Non-qualified annuities bought with after-tax money are not subject to RMD rules at all.

Reporting the Income on Your Return

Your annuity issuer reports your payments on Form 1099-R by January 31 each year.⁹ Box 1 shows the gross distribution for the year. Box 2a shows the taxable amount, with the exclusion ratio already applied for a non-qualified contract; for a qualified contract Box 2a usually matches Box 1.¹⁰ Box 5 shows your after-tax investment in the contract, if any.

You report the Box 2a figure on Form 1040 as ordinary income. If you believe the issuer applied the exclusion ratio incorrectly, which can happen when a contract has been transferred between insurers, you can calculate the correct amount using Publication 939 and report the adjusted figure. Keep the original contract and premium records to support your calculation if the IRS asks.⁵

State Tax Is a Separate Question

Federal tax is only part of the picture. Most states with an income tax also tax annuity payments as ordinary income, though some offer partial exclusions for pension and annuity income that can shield a portion of your payments. A few states have no income tax at all. Check your state’s rules before assuming the federal treatment is the whole story.

1
Internal Revenue Service. Topic No. 410, Pensions and Annuities
2
eCFR. 26 CFR 1.72-4 – Exclusion Ratio
3
Internal Revenue Service. Publication 575, Pension and Annuity Income
4
Office of the Law Revision Counsel. 26 US Code 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts
5
Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities
6
Internal Revenue Service. Net Investment Income Tax
7
eCFR. 26 CFR Part 1 – Net Investment Income Tax
8
Congress.gov. Required Minimum Distribution (RMD) Rules for Original Account Holders
9
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
10
Internal Revenue Service. Instructions for Forms 1099-R and 5498