How Non-Qualified Annuities Are Taxed: Withdrawals and Penalties

Non-qualified annuities are taxed on an earnings-first basis: because you funded the contract with after-tax dollars, your original principal returns tax-free, but every dollar of gain is taxed as ordinary income when it comes out. Rates run from 10% to 37% depending on your bracket, and the timing rules, penalties, and beneficiary treatment change based on how the money leaves the contract.

Growth Inside the Contract Is Tax-Deferred

While your money sits inside the annuity, the IRS does not tax the interest, dividends, or investment gains each year. Compare that to a brokerage account, where realized gains and dividends generate a tax bill annually. Inside the annuity, everything compounds without that drag. This is the core reason people use non-qualified annuities, typically after maxing out 401(k)s and IRAs.

The trade-off matters. When you eventually withdraw, the gains are taxed as ordinary income rather than at the lower long-term capital gains rates a taxable account would offer. For someone in a high bracket, that gap is meaningful. Deferral only pays off if the years of uninterrupted compounding outrun the higher rate you’ll owe on the back end.

Withdrawals Before You Annuitize: Earnings Come Out First

When you pull money from a non-qualified annuity without converting it to a payment stream, the tax code treats the first dollars out as gain, not as a return of principal. You keep withdrawing taxable earnings until the total you’ve taken equals the total gain in the contract. Only then does tax-free principal start coming back.¹ Early withdrawals therefore carry the heaviest tax hit.

Say you invested $100,000 and the contract is now worth $160,000. Withdraw $30,000, and the entire $30,000 is taxable, because the contract holds $60,000 of gain and you haven’t exceeded that figure. Nothing comes back tax-free until you’ve pulled out more than $60,000. The taxable amount is added to your other income and taxed at your marginal rate, which for 2026 runs from 10% on the first $12,400 of taxable income up to 37% on income above $640,600 for single filers.²

One structural point worth knowing: if you own multiple annuity contracts bought from the same insurer in the same calendar year, the IRS treats them as a single contract for this calculation.³ You can’t split money across contracts and cherry-pick the one with the smallest gain. Contracts from different carriers, or bought in different years, are tracked separately.

Annuitized Payments Use an Exclusion Ratio

When you convert the contract to a stream of periodic payments, the math shifts in your favor. Each payment is split into a taxable portion and a tax-free portion using an exclusion ratio: your total investment in the contract divided by the expected total return over your lifetime.¹

If you invested $100,000 and the expected total payout based on your life expectancy is $200,000, the exclusion ratio is 50%. Half of each check comes back tax-free as principal; the other half is taxable. IRS Publication 939 walks through the calculation using the agency’s life expectancy tables.⁴

Once you’ve recovered your entire original investment through those tax-free portions, every subsequent payment is fully taxable.⁴ Live well past your projected life expectancy, and you eventually shift to 100% taxable payments. That’s the price of the favorable split during the earlier years.

The 10% Penalty Before Age 59½

On top of ordinary income tax, the IRS charges a 10% penalty on the taxable portion of any withdrawal you take before age 59½.¹ Pull $20,000 of earnings at age 50 and you owe income tax on the full $20,000 plus a $2,000 penalty. The penalty applies only to the gain portion. Once you’re withdrawing principal, there’s no penalty because there’s no taxable amount.

Several exceptions let you avoid the 10% surcharge:

You become disabled as defined by the tax code, meaning an impairment expected to last indefinitely or result in death.
You take substantially equal periodic payments spread over your life expectancy, or the joint life expectancy of you and a beneficiary. These must continue for at least five years or until you reach 59½, whichever is later.
You receive payments under an immediate annuity, where payouts begin within one year of purchase.
The distribution is made to a beneficiary after the owner’s death.
The withdrawal is allocable to contributions made before August 14, 1982, a grandfathering provision that rarely applies today.

The substantially equal periodic payment route is the most common workaround for people needing income before 59½. The rules are unforgiving: modify the payment schedule before you complete the required time period and the IRS retroactively applies the penalty to every distribution you already took.¹

The 3.8% Net Investment Income Tax

Higher earners face an additional layer. The net investment income tax adds 3.8% on top of regular income tax, and annuity distributions count as investment income under the statute.⁵ It kicks in when your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly. Those thresholds are not indexed for inflation, so they’ve been pulling in more taxpayers each year since the tax took effect in 2013.

The 3.8% applies to the lesser of your net investment income or the amount your MAGI exceeds the threshold. A large one-year withdrawal can push you over the line even if your salary alone wouldn’t. Spreading withdrawals across multiple tax years is one common response. While money sits untouched inside the contract, the NIIT does not apply, because nothing is being distributed.

What Happens When the Owner Dies

Non-qualified annuities do not receive a stepped-up cost basis at death. Where stocks and real estate get a fresh basis, annuities are specifically excluded from that treatment.⁶ The beneficiary inherits the full income tax liability on every dollar of gain. If the original owner invested $80,000 and the contract is worth $200,000 at death, the beneficiary owes income tax on $120,000 of gain.

Distribution Deadlines for Beneficiaries

How fast the beneficiary must take the money depends on whether the owner had begun receiving annuity payments. If the owner died before annuitizing, the entire contract must be distributed within five years of the owner’s death.¹ Withdrawals can happen all at once or across the five years, but the account must be empty by that deadline.

An individual beneficiary can instead elect to stretch distributions over their own life expectancy, which spreads the taxable gain across many years and often reduces the annual bite. To qualify, the beneficiary must begin taking payments within one year of the owner’s death.¹ Trusts, estates, and charities do not qualify for the stretch and are stuck with the five-year rule.

Surviving Spouse Continuation

A surviving spouse who is the named beneficiary has an option no one else gets: step into the deceased owner’s position and continue the contract as their own.¹ There’s no immediate tax liability, the contract keeps growing tax-deferred, and distributions can wait until the surviving spouse chooses to take them.

Gifting or Assigning the Contract

Giving a non-qualified annuity to anyone other than a spouse is a taxable event for the giver. If you transfer the contract without receiving full value in return, the IRS treats you as having received the difference between the cash surrender value and your investment in the contract. You owe ordinary income tax on that gain, even though no cash actually changed hands.¹

Transfers to a spouse, or as part of a divorce settlement, are the exception. They fall under the general rule that spousal transfers don’t trigger gain recognition.¹ The receiving spouse takes over the original cost basis and the deferred tax liability that comes with it. In divorce negotiations, that embedded tax can make a $200,000 annuity worth noticeably less than $200,000 of cash.

1035 Exchanges to Switch Contracts

Section 1035 of the tax code lets you move money from one annuity contract to another without triggering tax. Exchanges into qualified long-term care insurance contracts are also allowed.⁷

The transfer must go directly from one insurance company to the other. The money can never pass through your hands. The contracts must relate to the same insured person, and the contract owner must remain the same.⁸ Take a check and reinvest it yourself, and the IRS treats the original contract as fully surrendered, making all accumulated gain immediately taxable.

Corporate and Trust Ownership

p>Tax deferral disappears when the contract is held by a corporation, LLC, or other entity that is not a natural person. The annual increase in contract value becomes taxable as ordinary income each year, even without a withdrawal.¹

A trust that holds the annuity as agent for a natural person is treated differently. If the beneficial owner is an individual, the contract keeps its tax-deferred status. This commonly comes up with revocable living trusts, where the grantor is both trust creator and beneficial owner. Irrevocable trusts are harder, and the answer often turns on whether the trust genuinely acts as agent for an identifiable individual.⁹ Immediate annuities and contracts acquired by a decedent’s estate are also exempt from the entity-ownership rule.¹

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
5
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
6
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
7
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
8
Internal Revenue Service. Revenue Ruling 2007-24
9
Internal Revenue Service. Private Letter Ruling 202118002