How Are Non-Qualified Annuities Taxed: Withdrawals, Penalties, and Payouts

Non-qualified annuities are taxed on a last-in, first-out basis: the earnings come out before your original contribution, and those earnings are taxed as ordinary income at federal rates of 10% to 37% for 2026.¹ Your original investment comes back tax-free because you funded the contract with money you had already paid income tax on. Pull money out before age 59½ and the IRS adds a 10% penalty on the taxable portion, and higher-income owners may owe another 3.8% net investment income tax on top of that.

Withdrawals Before You Annuitize

If you take money out of a non-qualified annuity before converting it into a stream of payments, the IRS treats the first dollars as earnings, not as a return of what you put in. Every withdrawal is fully taxable until all the growth has been drained from the contract.² If a $50,000 investment has grown to $75,000, the first $25,000 you take out is entirely taxable. Only after every dollar of gain is gone does the IRS let you recover your after-tax contribution without owing more tax.

Those earnings are taxed at your marginal rate as ordinary income. The 2026 brackets start at 10% on the first $12,400 of taxable income for a single filer and climb to 37% on income above $640,600.¹ Annuity gains never qualify for the lower long-term capital gains rates, no matter how long the money has sat in the contract. A large withdrawal can push you into a higher bracket for the year.

The insurance company reports each distribution on Form 1099-R. The gross amount appears in Box 1 and the taxable amount in Box 2a.³ During the accumulation phase, when the full withdrawal is earnings under the last-in, first-out rule, those boxes usually match. Once you start getting your basis back, they split.

How Annuity Payments Are Taxed: The Exclusion Ratio

Once you annuitize and begin receiving a stream of payments, the last-in, first-out rule no longer applies. Instead, the IRS uses an exclusion ratio to divide each payment between taxable earnings and a tax-free return of your investment. You calculate the ratio by dividing your total investment in the contract by the expected return over the payout period, using the life expectancy tables in IRS Publication 939.⁴

If you invested $100,000 and the tables project $200,000 in total payments over your lifetime, your exclusion ratio is 50%. Half of every payment is tax-free and half is ordinary income. The ratio stays fixed for the life of the contract, even if payments later rise under a cost-of-living adjustment, and any increase above the original payment amount is fully taxable.⁴

You apply the ratio until you have recovered your full after-tax investment. After that, every remaining payment is 100% taxable because the IRS considers all remaining money in the contract to be earnings.

The 10% Early Withdrawal Penalty

Taxable money taken from a non-qualified annuity before age 59½ triggers an additional 10% tax on the portion included in your gross income.⁵ The penalty stacks on top of regular income tax and any net investment income tax. Pull $10,000 of earnings in the 24% bracket while over the NIIT threshold, and you owe $3,780 in combined federal tax on that one withdrawal.

Several exceptions remove the penalty:

The substantially equal payment exception has a trap. If you change the schedule before you have maintained it for five full years or before turning 59½, whichever is later, the IRS retroactively imposes the 10% penalty on every distribution you took under the arrangement, plus interest.⁶ Once you start, you are locked in.

The 3.8% Net Investment Income Tax

Taxable distributions from a non-qualified annuity count as net investment income, which can trigger the 3.8% Medicare surtax on top of regular income tax.⁷ The surtax applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds these thresholds:⁸

Single or head of household: $200,000
Married filing jointly: $250,000
Married filing separately: $125,000

These thresholds are set by statute and are not indexed for inflation. A single large withdrawal can push someone over the line even when their salary alone falls well below it, which is a strong argument for spreading taxable distributions across years when you can.

What Happens When the Owner Dies

Non-qualified annuities do not receive a step-up in cost basis at death. Unlike stocks or real estate, where heirs often inherit at current market value, a beneficiary inherits the original owner’s cost basis and owes ordinary income tax on all accumulated growth in the contract.²

Payout Deadlines for Beneficiaries

If the owner dies before annuity payments have started, the entire contract value must generally be distributed within five years. If the owner dies after payments have begun, the remainder must be paid out at least as quickly as the method already in use. A designated individual beneficiary can avoid the five-year deadline by electing to receive distributions over their own life expectancy, provided payments begin within one year of the owner’s death.⁶ Stretching payments keeps each year’s taxable amount smaller and lets the remaining balance keep growing tax-deferred.

A beneficiary who takes the full death benefit as a lump sum pays ordinary income tax on all the growth in one tax year. On a contract with $150,000 of earnings, that can push the recipient into the top bracket and trigger NIIT. When the beneficiary chooses annuity payments instead, the exclusion ratio applies and each installment is split between taxable earnings and tax-free return of basis.²

The Surviving Spouse Option

A surviving spouse who is the designated beneficiary can step into the role of contract owner as if the annuity had always been theirs.⁶ The five-year rule and the life-expectancy payout both fall away. The spouse can continue tax deferral indefinitely and decide when to begin withdrawals. No other class of beneficiary gets this treatment.

Switching Contracts: Section 1035 Exchanges

Section 1035 of the Internal Revenue Code lets you swap one non-qualified annuity for another (or for a qualified long-term care contract) with no gain or loss recognized at the time of the transfer.⁹ Your original cost basis carries over, and tax deferral continues uninterrupted.

The exchange has to be a direct transfer between insurance companies. If you take a check or gain control of the funds at any point, the IRS treats the transaction as a taxable distribution of your earnings. You can also exchange only part of one contract into a new one, but a partial 1035 exchange carries a 180-day holding requirement: taking a distribution from either contract during that window undoes the tax-free treatment.¹⁰

Gifting or Transferring an Annuity

Giving a non-qualified annuity to someone else triggers an immediate tax bill for the person making the gift. When you transfer a contract without receiving full value in return, the IRS treats you as if you received the difference between the cash surrender value and your cost basis, and that gain becomes ordinary income to you in the year of the transfer.⁶ The recipient’s cost basis then increases by the amount of gain you reported, so the same dollars are not taxed twice.

Transfers between spouses, or as part of a divorce settlement, do not trigger this tax.⁶

Two Traps That Undo the Tax Benefit

Entity Ownership

Tax deferral depends on a human owning the contract. If a corporation, LLC, or other non-natural entity holds the annuity, the IRS does not treat it as an annuity for tax purposes, and the annual growth is taxed as ordinary income to the entity each year, like interest in a bank account. Narrow exceptions apply to contracts acquired by an estate at death, contracts held under a qualified retirement plan, and immediate annuities.⁶

The Aggregation Rule

Buying multiple annuity contracts from the same insurance company in the same calendar year does not give you separate tax buckets. The IRS treats those contracts as a single annuity when calculating the taxable portion of withdrawals.⁶ If you want contracts kept separate for withdrawal purposes, buy them from different insurers or in different calendar years.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
3
Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025)
4
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
5
Internal Revenue Service. Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs
6
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
8
Internal Revenue Service. Net Investment Income Tax
9
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
10
IRS.gov. Section 1035 (Also 72) Rev. Proc. 2011-38