Is Cashing Out an Annuity Considered Income?

Yes, cashing out an annuity is considered income by the IRS, and the payout is taxed as ordinary income in the year you receive it. How much of the check is actually taxable depends on how the annuity was funded: if it sits inside a 401(k) or traditional IRA, every dollar is taxable; if you bought it with money you’d already paid taxes on, only the growth is taxable. Anyone under 59½ typically owes an extra 10% penalty on top.

How Much of the Payout the IRS Taxes

The split between “all taxable” and “only the earnings taxable” comes down to one question: did you get a tax deduction when the money went in?

A qualified annuity lives inside a tax-advantaged retirement account like a 401(k) or traditional IRA. The premiums went in pre-tax, so the IRS has never touched any of it. When you cash out, the entire distribution is ordinary income, including what you originally contributed. There is no cost basis to recover tax-free.

A non-qualified annuity was purchased with after-tax dollars from a savings or brokerage account. Because you already paid income tax on the premiums, the IRS only taxes the growth. When you surrender the contract, the insurance company subtracts your total premiums (your cost basis) from the final cash value, and the difference is your taxable gain. A common misconception is that this gain qualifies for the lower long-term capital gains rate. It doesn’t. Annuity earnings are taxed as ordinary income at rates that for 2026 run from 10% to 37% depending on your total taxable income and filing status.¹

One rule catches people off guard. Under IRC Section 72(e), when you take money out of a deferred annuity before it has been annuitized, the IRS treats earnings as coming out first. Your withdrawal is fully taxable up to the amount by which the contract’s cash value exceeds your cost basis. Only after all the earnings have been withdrawn does anything come back as a tax-free return of principal. A partial withdrawal from a non-qualified annuity that’s grown in value is therefore taxable dollar-for-dollar until you’ve pulled out all the gain.²

The 10% Early Withdrawal Penalty

Cashing out before age 59½ adds a 10% additional tax on the taxable portion of the distribution. For qualified annuities the penalty comes from IRC Section 72(t); for non-qualified annuities it comes from Section 72(q). The math is identical: 10% of whatever amount is included in your gross income, stacked on top of regular income tax.²

For a non-qualified annuity, the penalty applies only to the earnings, since your original premiums aren’t taxable to begin with. For a qualified annuity, the entire distribution is subject to the penalty because the entire distribution is taxable income. You calculate and report the penalty on Form 5329 with your annual return.³

Several situations let you avoid the 10% penalty on a non-qualified annuity cash-out:

You’re age 59½ or older.
The contract holder has died and you’re receiving proceeds as a beneficiary.
You have become totally and permanently disabled.
You take substantially equal periodic payments (SEPP) based on your life expectancy.
The contract is an immediate annuity bought with a lump sum that begins paying out within one year.

Qualified plans under Section 72(t) share most of these exceptions and add others, including distributions used for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.⁴

The SEPP exception is the one most often used by people who need annuity money before 59½. Once you set it up, you commit to fixed annual distributions for at least five years or until you reach 59½, whichever is later. You cannot take extra withdrawals or modify the schedule during that period. If you break the schedule, the IRS applies a recapture tax: the 10% penalty applies retroactively to every distribution you took since the schedule began, plus interest.⁵

Withholding at Payout Is Not Your Final Bill

The amount of tax withheld when you cash out often doesn’t match what you’ll actually owe.

Qualified plan payouts have mandatory 20% federal withholding. The plan administrator takes that off the top before sending you the check.⁶ That 20% is a prepayment. If your marginal rate lands in the 24% bracket, you’ll still owe the difference at filing time. If it lands lower, you’ll get some back.

Non-qualified annuity distributions default to 10% federal withholding on the taxable portion. You can elect out of withholding entirely or request a higher rate, but electing out and then owing tax can produce an underpayment penalty when you file.⁷

High earners face one more layer. The taxable gain from a non-qualified cash-out is net investment income, which can trigger the 3.8% Net Investment Income Tax. NIIT applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $250,000 (married filing jointly or qualifying surviving spouse), $200,000 (single or head of household), or $125,000 (married filing separately). If the cash-out pushes you above the threshold, 3.8% stacks on top of the ordinary income tax and any early withdrawal penalty.⁸

Ripple Effects on Social Security and Medicare

Because the payout adds to your adjusted gross income, it can do damage in two other places that catch retirees off guard.

Social Security Benefits

The IRS uses “provisional income” (your AGI, plus tax-exempt interest, plus half of your Social Security benefits) to determine how much of your Social Security is taxable. The gain from an annuity cash-out flows straight into AGI. For single filers, provisional income between $25,000 and $34,000 makes up to 50% of benefits taxable; above $34,000, up to 85% is taxable. Joint filers hit those tiers at $32,000 and $44,000. Those thresholds have never been indexed for inflation, so a large liquidation can easily push a retiree into the 85% zone.

Medicare Part B Premiums

Medicare Part B is income-tested through the Income-Related Monthly Adjustment Amount (IRMAA). The standard 2026 Part B premium is $202.90 per month, but higher income means a higher premium. Surcharges for single filers begin when modified adjusted gross income exceeds $109,000. At the top tier (above $500,000 single or $750,000 joint), the monthly premium reaches $689.90.⁹

IRMAA uses a two-year lookback, so a large 2026 cash-out can raise your Medicare premiums in 2028. A jump from $100,000 to $150,000 in income could add roughly $81 per month to Part B, close to $975 for the year, on top of the income tax you already paid on the same money.

State Income Taxes

Federal treatment is only half the picture. Most states with an income tax treat annuity distributions as taxable income. A few states have no income tax at all. Others offer partial exclusions for retirement income, but the rules differ widely: some exempt annuity income only above a certain age or below an income cap, and some fully tax private annuities while exempting government pensions. Check your state’s rules before you liquidate.

What Arrives at Tax Time: Form 1099-R

The insurance company reports the distribution to you and the IRS on Form 1099-R for any payout of $10 or more, delivered by January 31 of the following year.¹⁰ A few boxes matter:

Box 1 shows the gross distribution before withholding.
Box 2a shows the taxable amount. For a qualified annuity this usually equals Box 1. For a non-qualified annuity it reflects only the earnings.
Box 2b, if checked, means the insurance company couldn’t determine the taxable amount and you have to calculate it yourself.
Box 7 carries a distribution code. Code 7 is a normal distribution with no penalty. Code 1 is an early distribution subject to the 10% additional tax. If the code says 1 but you qualify for an exception, claim the exception on Form 5329.¹¹

The IRS receives its own copy and matches it to your return, so ignoring the form or misreporting the numbers is one of the fastest ways to draw a notice.

Ways to Avoid the Tax Hit if You Don’t Actually Need the Cash

If your goal is to get out of a specific contract rather than to spend the money, two options move the funds without producing taxable income.

A direct rollover works for qualified annuities. You ask the plan administrator to send the distribution straight to another eligible retirement plan or IRA, with the check made payable to the receiving custodian. No taxes are withheld and none are due; the balance keeps growing tax-deferred until you eventually take distributions from the new account.¹²

A 1035 exchange works for non-qualified annuities. Under IRC Section 1035, you can move the contract value into a new annuity, or into a qualified long-term care insurance policy, without triggering a taxable event. The exchange has to go directly between insurance companies; you can’t take possession of the funds first. Your original cost basis carries over to the new contract, so this defers tax rather than eliminates it. The exchange cannot transfer property to a non-U.S. person.¹³

Neither route erases contract-level surrender charges the insurer may impose, which are separate from taxes. But both keep the IRS out of the transaction, and both preserve the tax-deferred growth you’d otherwise give up by cashing out.

1
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
2
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
3
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
4
Internal Revenue Service. Topic No. 558, Additional Tax on Early Distributions From Retirement Plans Other Than IRAs
5
Internal Revenue Service. Substantially Equal Periodic Payments
6
Internal Revenue Service. 401(k) Resource Guide Plan Participants General Distribution Rules
7
Internal Revenue Service. Pensions and Annuity Withholding
8
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
9
Centers for Medicare & Medicaid Services (CMS). 2026 Medicare Parts A and B Premiums and Deductibles
10
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
11
Internal Revenue Service. Instructions for Forms 1099-R and 5498
12
Internal Revenue Service. Rollovers of Retirement Plan and IRA Distributions
13
Office of the Law Revision Counsel. 26 U.S. Code 1035 – Certain Exchanges of Insurance Policies