An annuity pays out in one of three ways: a single lump sum, a series of scheduled withdrawals you control, or a stream of guaranteed periodic payments — called annuitization — that can run for a set number of years or for the rest of your life. The size of each payment and the tax you owe on it depend on your age, the payout schedule you choose, and whether the contract was funded with pre-tax or after-tax dollars.
The Three Payout Options
Most contracts offer more than one way to take your money, and each involves a different trade-off between control and guaranteed income.
Lump sum. You withdraw the entire account value, or a large portion of it, at once. You keep full control of the money, but you lose any future guarantees the contract offered, and the taxable portion is recognized in a single year. That can push you into a higher tax bracket.
Systematic withdrawals. You set up a recurring withdrawal — say, a fixed dollar amount every month — without permanently converting the contract into an income stream. You keep control of the remaining balance, can adjust or stop the withdrawals, and the rest of the account continues to earn interest or investment returns. Surrender charges may apply during the early years of the contract.
Annuitization. You permanently convert your account balance into a guaranteed series of payments from the insurance company. Once you annuitize, you typically cannot access the principal as a lump sum, change the payment amount, or reverse the decision. In exchange, the insurer contractually promises payments for whatever period you selected, including for life.
Many retirees combine approaches, taking systematic withdrawals during the early years of retirement and annuitizing later, when a guaranteed lifetime income stream becomes more valuable.
Annuitization Schedules
If you annuitize, the next decision is how long payments last and what happens if you die before the contract is fully paid out.
Life only. Payments continue for your entire lifetime and stop when you die. Because the insurer owes nothing to anyone else, this schedule produces the highest monthly payment. If you die shortly after annuitizing, the remaining balance stays with the insurance company and nothing passes to your heirs.
Joint and survivor. Payments continue until the second of two people (usually spouses) dies. Monthly payments are lower than a life-only schedule because the insurer expects to pay for a longer combined period. Some contracts reduce the payment by a set percentage, often 50% or one-third, after the first person dies.
Period certain. Payments are guaranteed for a fixed number of years, commonly 10 or 20. If you die before the period ends, remaining payments go to your named beneficiary. If you outlive the period, payments stop.
Life with period certain. A combination that guarantees income for life while also protecting a minimum number of years. If you die five years into a life-with-20-year-certain schedule, your beneficiary receives the remaining 15 years of payments. If you live past the 20-year mark, payments continue until you die.
Some contracts also offer a cost-of-living adjustment rider that raises payments each year by a fixed percentage, often between 1% and 6%. Adding the rider reduces your initial payment because the insurer is committing to higher payments later.
What Determines the Size of Each Payment
The insurer calculates your periodic payment from your account balance at the time you annuitize plus several other variables:
- Your age. Older annuitants receive larger payments because the insurer expects to make payments over a shorter period, based on actuarial mortality tables.
- Your payout schedule. A life-only schedule pays more per period than joint-and-survivor or period-certain, because the insurer’s total expected obligation is smaller.
- Interest rates at the time you annuitize. Higher rates generally produce larger payments, because the insurer can earn more on the remaining principal while paying you. Locking in during a low-rate environment means smaller payments that typically cannot be renegotiated.
- Fixed vs. variable. A fixed annuity pays the same amount each period. A variable annuity fluctuates with the performance of the investment sub-accounts you chose — good years raise your check, bad years lower it.
How Often Payments Arrive
You select the payment frequency when you set up the payout: monthly, quarterly, semi-annual, or annual. Monthly is the most common for retirees replacing a paycheck. Most insurers deposit payments directly into your bank account by electronic transfer, though some contracts still offer paper checks.
How Annuity Payments Are Taxed
Federal tax rules for annuity distributions depend on whether the contract was funded with pre-tax or after-tax dollars.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
Qualified Annuities
A qualified annuity sits inside a tax-advantaged retirement account such as an IRA or 401(k) and was funded with pre-tax dollars. Because you never paid income tax on the contributions or the growth, every dollar you receive is fully taxable as ordinary income in the year you receive it.
Non-Qualified Annuities and the Exclusion Ratio
A non-qualified annuity was purchased with after-tax money. The IRS does not tax you again on the return of that original investment. Instead, each payment is split into a tax-free return of principal and a taxable earnings portion, and the split is set by the exclusion ratio.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The exclusion ratio equals your total after-tax investment divided by the expected total return under the contract. If you invested $60,000 and the insurer’s expected total return over your lifetime is $100,000, your ratio is 60%. That makes 60% of each payment a tax-free return of principal, with the remaining 40% taxed as ordinary income. Once you have recovered your entire original investment, every subsequent payment becomes fully taxable.
What the Insurer Reports
Your insurance company reports all annuity distributions to the IRS each year on Form 1099-R and sends you a copy.2Internal Revenue Service. Instructions for Forms 1099-R and 5498 The form breaks out the gross distribution and the taxable amount, which you use when filing your return.
The 10% Early Withdrawal Penalty
Take money from an annuity before age 59½ and the taxable portion of the withdrawal is generally hit with a 10% additional federal tax on top of regular income tax.1Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The penalty applies to both qualified annuities (under §72(t)) and non-qualified annuities (under §72(q)), with slightly different exceptions.
For non-qualified annuities, the penalty does not apply to distributions:
- Made after age 59½
- Made after the death of the contract holder
- Due to disability
- Part of a series of substantially equal periodic payments made at least annually over your life expectancy (or the joint life expectancies of you and your beneficiary)
- From an immediate annuity contract, meaning one that begins payments within a year of purchase
The substantially equal periodic payment exception (sometimes called a 72(q) distribution or SEPP) lets you access annuity funds before 59½ without the penalty, but you must stick to the schedule. Changing or stopping the payments before you turn 59½, or before five years have passed (whichever is later), retroactively triggers the 10% penalty on all prior distributions.
Surrender Charges on Early Withdrawal
Separate from the tax penalty, the insurer usually deducts a surrender charge if you withdraw money or cancel during the early years of the contract. The surrender period commonly lasts six to eight years, with the charge starting around 6% to 7% in the first year and declining by roughly one percentage point per year until it reaches zero.
Many contracts let you withdraw up to 10% of your account value each year during the surrender period without triggering the charge. Some also waive surrender charges entirely if you are confined to a nursing home or diagnosed with a terminal illness. Once the surrender period ends, no charge from the insurer applies, though tax penalties can still apply if you are under 59½.
Forced Payouts on Qualified Annuities
If your annuity is held inside a qualified retirement account, federal law requires you to begin taking minimum distributions at a certain age whether you need the money or not. Non-qualified annuities purchased with after-tax dollars are not subject to these rules.
Under current law, the required beginning age is 73 for individuals born between 1951 and 1959. Starting in 2033, the age rises to 75 for individuals born in 1960 or later.3Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans Your first distribution must be taken by April 1 of the year after you reach the applicable age; every distribution after that is due by December 31.
If your qualified annuity is already paying out as a life annuity or joint-and-survivor annuity, those periodic payments generally satisfy the RMD requirement automatically.4Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs If it has not been annuitized, you must withdraw at least the calculated minimum each year based on your balance and IRS life expectancy tables.
Missing an RMD carries a 25% excise tax on the amount you should have withdrawn. Correcting the shortfall within two years reduces the penalty to 10%.4Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
Payouts to a Beneficiary
Inherited annuities do not receive a stepped-up tax basis the way many other inherited assets do. The IRS treats any amount a beneficiary receives above the original owner’s after-tax investment as income in respect of a decedent, which means the beneficiary owes ordinary income tax on the same earnings the original owner would have been taxed on.5Internal Revenue Service. Revenue Ruling 2005-30
A beneficiary who takes a lump-sum death benefit owes tax on the entire amount above the owner’s investment in the year received. A beneficiary who elects payments over time is taxed under the same exclusion ratio rules that would have applied to the original owner. If the annuity was included in the deceased owner’s taxable estate and estate tax was paid, the beneficiary can claim a deduction for the portion of estate tax attributable to the inherited annuity income.5Internal Revenue Service. Revenue Ruling 2005-30
If the Insurance Company Fails
Because annuity payments depend on the issuing insurer’s financial health, every state maintains a life and health insurance guaranty association that steps in if an insurer becomes insolvent. These associations are funded by assessments on other licensed insurers in the state, not by tax dollars.
Coverage limits vary by state. Based on the National Association of Insurance Commissioners Model Act, the standard protection for the present value of annuity benefits is $250,000 per owner, per insurer, and a majority of states follow that figure.6NOLHGA. FAQs: Product Coverage Some states set the limit as low as $100,000; a handful go up to $500,000. Anything above your state’s limit is not guaranteed. Spreading large balances across multiple unrelated insurers is one way to stay within the caps, since the limit applies per insurer.