How Is an Annuity Taxed? Withdrawals, Penalties, and RMDs

An annuity is taxed as ordinary income on its earnings, with the timing and amount driven by how the contract was funded, how you take the money out, and how old you are when you do. If you funded it with pre-tax dollars inside a retirement plan, every dollar you withdraw is taxable. If you bought it on your own with after-tax money, only the growth is taxed, and part of each annuity payment comes back to you tax-free. Withdraw earnings before age 59½ and the IRS adds a 10% penalty on top. Those are the rules that decide how an annuity is taxed; the rest is detail about which one applies to your situation.

Qualified vs. Non-Qualified Annuities

Where the money came from decides almost everything else. A qualified annuity sits inside a tax-advantaged retirement plan such as a 401(k) or traditional IRA and was funded with pre-tax dollars. Because nothing in the contract has ever been taxed, the IRS treats every dollar you take out as ordinary income.¹

A non-qualified annuity is one you bought on your own with money you had already paid income tax on. The IRS only taxes the earnings when they come out, so you aren’t taxed twice on the principal.²

Either way, the insurance company reports each distribution on Form 1099-R, and that’s what you use to file.³ Ordinary income rates for 2026 top out at 37%, hitting above $640,600 for single filers and $768,700 for married couples filing jointly.⁴

How the Withdrawal Method Changes What You Owe

Annuitized Payments and the Exclusion Ratio

When you turn a non-qualified contract into a stream of regular payments, the IRS doesn’t tax the whole check. It applies an exclusion ratio: your investment in the contract divided by the expected return, based on a fixed payout term or your life expectancy at the annuity starting date.⁵

Say you invested $100,000 and the expected return over your lifetime is $200,000. The ratio is 50%. Half of each payment is a tax-free return of your principal; the other half is ordinary income.

There’s a cap. For any annuity that started after 1986, the total you can exclude across the life of the contract can’t exceed what you originally put in.⁵ Once you’ve recovered every dollar of principal that way, every future payment is fully taxable. If you die before recovering the full investment, the unrecovered amount can be claimed as an itemized deduction on your final return.

Lump-Sum Cash-Out

Taking the whole contract in one year makes all accumulated earnings taxable at once. On a contract that has grown substantially, that can push your income into the top bracket in a single filing year and erase the benefit of tax deferral. It’s the most expensive way to get your money out.

Partial and Systematic Withdrawals

Pulling money out of a contract that hasn’t been annuitized follows a less friendly rule. The IRS uses last-in, first-out: every dollar you withdraw is treated as taxable earnings until all the gains are gone.¹ Only after you’ve withdrawn and paid tax on every cent of growth can you start touching your original principal tax-free. Systematic withdrawals follow the same LIFO logic, so the flexibility of taking money as you need it comes at the cost of front-loaded taxation.

One more trap for people trying to game this: if you buy more than one non-qualified annuity from the same insurance company in the same calendar year, the IRS treats them as a single contract when figuring the taxable portion of any withdrawal.⁶ You can’t spread money across contracts and withdraw only from the one with the smallest gains.

The 10% Penalty for Withdrawing Before 59½

Withdraw taxable earnings from an annuity before age 59½ and the IRS adds a 10% penalty on top of the regular income tax. Section 72(q) covers non-qualified annuities; Section 72(t) covers annuities inside qualified plans.² The penalty only hits the taxable portion, not any tax-free return of principal.

Several situations avoid the penalty:

Distributions to a beneficiary after the owner dies.
Total and permanent disability of the contract owner.
A series of substantially equal periodic payments (SEPP) based on life expectancy, calculated using one of three IRS-approved methods.⁷
An immediate annuity: a single-premium contract that starts paying within one year of purchase and pays at least annually.²

The SEPP route has a lock-in. Change the payment amount before five years have passed or before you turn 59½, whichever comes later, and the IRS goes back and imposes the 10% penalty on every distribution you already received, plus interest.² Once the schedule starts, you’re committed.

The 3.8% Net Investment Income Tax

Higher-income filers face an extra layer. Taxable earnings from a non-qualified annuity count as net investment income and can trigger a 3.8% surtax once your modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).⁸ The surtax hits the lesser of your net investment income or the amount your MAGI exceeds the threshold. These thresholds aren’t indexed for inflation, so more filers cross them every year.

Stack the 3.8% surtax on top of the 37% ordinary rate and the effective federal rate on non-qualified annuity gains can reach 40.8%. A big lump-sum distribution is the most common way to walk into it, because it inflates both your investment income and your MAGI in the same year.

Required Minimum Distributions From Qualified Annuities

If your annuity sits inside a traditional IRA, a 401(k), or a similar qualified plan, you have to start taking required minimum distributions. Under SECURE 2.0, RMDs must begin by April 1 of the year after you turn 73. That threshold holds through 2032 and rises to 75 in 2033.⁹

If your qualified annuity is already paying an income stream that meets or exceeds the required amount, that generally satisfies the RMD. If the annuity is one holding inside an IRA alongside other investments, you need to make sure total distributions from that IRA hit the minimum.

Skip an RMD and the IRS charges a 25% excise tax on the amount you should have taken. Correct the shortfall within two years and the penalty drops to 10%.⁹ Non-qualified annuities are not subject to RMDs during the owner’s lifetime.

Taxes on an Inherited Annuity

Annuities don’t get the step-up in cost basis that inherited stocks and real estate receive. A beneficiary owes ordinary income tax on the difference between the owner’s original investment and the contract’s value at death.¹⁰

Non-Qualified Annuities

When the owner of a non-qualified contract dies before payments have started, Section 72(s) requires the entire contract value to be distributed within five years. A named individual beneficiary can instead stretch distributions over their own life expectancy if payments begin within one year of the owner’s death. If the owner had already started receiving payments, the beneficiary must continue at least as fast as the original schedule.²

A surviving spouse gets the best deal. The spouse can step into the contract as the new owner, keep the tax-deferred status, and choose when to begin distributions.²

Qualified Annuities

Annuities inside qualified plans follow SECURE Act rules instead. Since 2020, most non-spouse designated beneficiaries must empty the account by December 31 of the tenth year after the owner’s death. Life-expectancy stretching is reserved for a narrow group of eligible designated beneficiaries: the surviving spouse, a minor child of the deceased, a disabled or chronically ill individual, or a person no more than 10 years younger than the owner.¹¹

A beneficiary that isn’t an individual at all, such as the owner’s estate or a non-qualifying trust, falls under the old five-year rule and must liquidate the account within five years.¹²

Estate Tax

The death benefit is included in the deceased owner’s gross estate for federal estate tax to the extent it’s attributable to contributions the decedent or their employer made.¹³ For 2026, the federal estate tax exemption is $15,000,000, so this only matters for very large estates.¹⁴ When it does apply, the beneficiary can face both estate tax on the contract value and income tax on the earnings.

Switching Contracts Without a Tax Hit: Section 1035

If you want out of your current annuity because of fees, performance, or features, you don’t have to cash it out. Section 1035 lets you exchange one annuity for another without recognizing gain or loss, and the new contract can be with a completely different insurance company.¹⁵ The funds must move directly between carriers. If the money touches your hands, the IRS treats it as a distribution.

You can also exchange an annuity for a qualified long-term care policy under the same section.¹⁵ Partial exchanges work too, but neither the original contract nor the new one can make a non-annuity distribution within 180 days of the transfer or the IRS will treat the swap as a taxable event.¹⁶

One caveat that trips people up: a 1035 exchange only eliminates the tax consequence. If your current contract carries a surrender charge, the insurance company still deducts it from the transferred value.

How a Big Distribution Can Raise Your Medicare Premium

Annuity distributions count toward your modified adjusted gross income, and Medicare uses MAGI to set the income-related monthly adjustment amount (IRMAA) for Part B and Part D. A large withdrawal in one year can push you across an IRMAA threshold and raise your premiums the following year. In 2026, Part B IRMAA surcharges begin at $109,000 for individual filers and $218,000 for joint filers, with the highest surcharge reaching $487 per month for individuals above $500,000.¹⁷

A one-year income spike from a lump-sum payout can add up to thousands of dollars in extra Medicare premiums the next year, entirely separate from the income tax you already paid on the distribution. Spreading withdrawals across multiple years usually costs less if you’re on Medicare or close to it.

1
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
2
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. Form 1099-R 2025 Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
4
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
5
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
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. Substantially Equal Periodic Payments
8
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
9
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
10
Internal Revenue Service. Gifts and Inheritances
11
Internal Revenue Service. Retirement Topics – Beneficiary
12
Internal Revenue Service. Publication 590-B (2025), Distributions from Individual Retirement Arrangements (IRAs)
13
eCFR. 26 CFR 20.2039-1 – Annuities
14
Internal Revenue Service. Whats New – Estate and Gift Tax
15
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies
16
Internal Revenue Service. Tax Treatment of Certain Tax-Free Exchanges of Annuity Contracts Under Section 72 and Section 1035
17
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles