Partial Annuitization: Tax Rules, Penalties, and 1035 Exchanges

Partial annuitization tax rules split your contract into two tax tracks that behave very differently. The segment you convert to an income stream is taxed under the Internal Revenue Code Section 72 exclusion ratio, so each payment is part tax-free return of basis and part ordinary income. The segment you leave in the accumulation phase follows the earnings-first withdrawal rule, which means any money you pull out is fully taxable until you’ve distributed all the gain. On top of that, a 10% pre-59½ penalty, the 3.8% net investment income tax, and Medicare premium surcharges can each apply depending on your age, income, and whether the contract is qualified.

How the Contract Splits for Tax Purposes

When you partially annuitize, the insurer carves the contract in two. One piece becomes a guaranteed income stream (immediate or deferred). The other piece stays in accumulation and continues to grow tax-deferred.

For non-qualified contracts, your original basis (the after-tax premiums you paid in) is allocated proportionally. Annuitize $100,000 of a $400,000 contract and 25% of your total basis moves to the income stream; the remaining 75% stays with the retained portion. The allocation is permanent. You cannot later claim the retained portion’s basis against the annuitized income, or vice versa.

The Annuitized Portion: The Exclusion Ratio

For each payment from the annuitized segment, IRC Section 72(b) excludes from gross income the portion that bears the same ratio to the payment as your investment in the contract bears to the expected return.¹ The rest is taxable as ordinary income.

A worked example: suppose your total basis is $200,000 on a $400,000 contract, and you annuitize $100,000. The annuitized segment receives $50,000 of basis (25% of $200,000). If the insurer calculates an expected return of $150,000 on that income stream, your exclusion ratio is $50,000 ÷ $150,000, or 33.3%. Roughly one-third of each payment comes back tax-free; two-thirds is taxable ordinary income.

The exclusion is capped at your unrecovered investment immediately before each payment. Once you’ve recovered the full $50,000 of allocated basis, every subsequent payment is 100% taxable. The insurer reports the taxable and non-taxable portions on Form 1099-R each year.²

The Retained Portion: Earnings Come Out First

The retained accumulation portion follows a far less favorable rule. Under IRC Section 72(e), any withdrawal taken before the annuity starting date is treated as earnings first, taxable as ordinary income, until all the gain in the contract has been distributed. Only after you’ve withdrawn all the earnings does the remaining balance become a tax-free return of basis.¹

The statute spells out the math: a withdrawal is allocable to income to the extent it doesn’t exceed the excess of the contract’s cash value (ignoring surrender charges) over the investment in the contract at that time. Everything beyond that is allocable to basis. In practice, early withdrawals from the retained portion hit at your full ordinary rate with no exclusion ratio benefit.

That gap drives a real planning tension. The annuitized side blends taxable income and tax-free basis in every payment from day one. The retained side forces you to recognize all the gain before any basis comes back.

When the Annuity Is Inside an IRA or 403(b)

If the contract sits inside a qualified plan like a traditional IRA or 403(b), the picture simplifies. There is no exclusion ratio and no basis allocation, because contributions went in pre-tax. Every annuitized payment and every retained-side withdrawal is fully taxable as ordinary income. The only exception is any non-deductible contributions you may have made, which retain their basis.

Qualified annuities also interact with the required minimum distribution rules. Under SECURE 2.0, you must begin RMDs at age 73, or age 75 if you were born in 1960 or later. Annuity payments from the annuitized portion generally count toward your RMD obligation for that account. The IRS has delayed final regulations on how partial annuitization specifically satisfies RMD requirements until at least January 1, 2027, and in the meantime owners and plan administrators are expected to follow a reasonable, good-faith interpretation of the statute.

The 10% Early Distribution Penalty

Taxable withdrawals from the retained portion before age 59½ carry a 10% additional tax under IRC Section 72(q). This is the annuity-specific counterpart to the Section 72(t) penalty that applies to qualified plans.¹

Several exceptions eliminate the penalty: distributions after the holder’s death, distributions attributable to disability, and payments structured as substantially equal periodic payments over your life expectancy. Payments received under an immediate annuity contract are also exempt, which means the annuitized side of a partial annuitization generally avoids the 10% tax even if you’re under 59½.¹

The 3.8% Net Investment Income Tax

The taxable portion of non-qualified annuity income counts as net investment income under IRC Section 1411. If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), you owe an additional 3.8% surtax on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.³ These thresholds are not indexed for inflation, so they catch more taxpayers each year.

Distributions from qualified plans such as IRAs and 403(b)s are not subject to the NIIT.⁴ If you hold both types of contracts, the non-qualified payments carry the NIIT exposure on top of ordinary income tax.

Medicare IRMAA Exposure

Annuity income of any kind, whether from the annuitized stream or a retained-side withdrawal, raises your MAGI. If that pushes you above certain thresholds, you’ll pay Income-Related Monthly Adjustment Amounts on your Medicare Part B and Part D premiums. The surcharge is based on your return from two years prior, so a large annuitization in 2026 affects your 2028 premiums.

The 2026 Part B IRMAA surcharges are:⁵

Single MAGI up to $109,000 (joint up to $218,000): no surcharge
$109,001–$137,000 (joint $218,001–$274,000): $81.20 per month
$137,001–$171,000 (joint $274,001–$342,000): $202.90 per month
$171,001–$205,000 (joint $342,001–$410,000): $324.60 per month
$205,001–$499,999 (joint $410,001–$749,999): $446.30 per month
$500,000 or more (joint $750,000 or more): $487.00 per month

Part D carries its own surcharges at the same income brackets, ranging from $14.50 to $91.00 per month. Because partial annuitization lets you control how much income you generate each year, you can calibrate the split to stay below an IRMAA threshold that full annuitization would blow through.

Partial 1035 Exchanges

Rather than annuitizing inside the same contract, you can transfer a portion of one annuity’s cash value directly into a new annuity through a partial 1035 exchange. Under Revenue Procedure 2011-38, the transfer qualifies for tax-free treatment under IRC Section 1035 as long as no amounts are received from either contract during the 180 days following the transfer.⁶

One important carve-out from that 180-day rule: amounts received as an annuity for a period of 10 years or more, or over one or more lives, don’t count. So you can transfer a portion into a new contract and immediately begin annuitizing it there, provided the payout term meets the 10-year-or-life requirement.⁶ That route is useful when your existing carrier’s payout rates are uncompetitive.

Medicaid Annuity Requirements

If long-term care Medicaid eligibility is in the picture, the tax rules above aren’t the only ones that matter. Under federal law, the purchase of an annuity by someone applying for nursing facility coverage is treated as an uncompensated transfer (which triggers a penalty period) unless the annuity meets strict requirements. The state Medicaid agency must be named as the remainder beneficiary in the first position for at least the total medical assistance paid, or in the second position after a community spouse or minor or disabled child.⁷

The annuity must also be irrevocable, non-assignable, and actuarially sound, with equal payments during its term and no deferred or balloon payments.⁷ State implementation varies. Beneficiary designations and payout structure need to meet these requirements from the start, because retroactive changes to an irrevocable annuity are not possible.

Keep the Confirmation Paperwork

After the insurer completes the split, you receive a confirmation document showing the allocated basis for each portion, the exclusion ratio for the annuitized segment (on non-qualified contracts), and the payment schedule. Keep it permanently. It’s the foundation for every tax return you file while either portion exists, and reconstructing those numbers years later is difficult if the documentation is lost.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025)
3
Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax
4
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
5
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
6
Internal Revenue Service. RP-2011-38 – Partial Exchange of Annuity Contracts
7
Office of the Law Revision Counsel. 42 USC 1396p – Liens, Adjustments and Recoveries, and Transfers of Assets