Taxation of Annuities: Rules, Penalties, and Inherited Accounts

Annuity taxation works on a simple frame with sharp edges: earnings grow tax-deferred inside the contract, and when money comes out it is taxed as ordinary income at federal rates ranging from 10% to 37% for 2026. What you actually owe depends on three things: whether the annuity was funded with pre-tax or after-tax dollars, how you take distributions, and how old you are when payments begin. Getting any one of those wrong can add a penalty tax on top of the regular income tax.

Why the Money Grows Untaxed Until You Touch It

Investment gains inside an annuity are not taxed each year as they accumulate. Interest, dividends, and capital gains compound without any annual tax drag, which can produce meaningfully larger balances over decades than a taxable brokerage account earning the same return.¹

The insurance company tracks that growth internally. Nothing hits your tax return until you take a distribution. Once you do, the rules for calculating tax split sharply depending on whether the contract is qualified or non-qualified.

Qualified Annuities: Every Dollar Is Taxable

A qualified annuity sits inside a tax-advantaged retirement account such as a 401(k), 403(b), or traditional IRA. Contributions went in with pre-tax dollars, so the IRS has never collected income tax on any of it. Every dollar that comes out is taxed as ordinary income at your current federal rate.² There is no tax-free portion, no exclusion ratio, no separation of principal and earnings. The entire distribution counts as taxable income for the year you receive it.³

Required Minimum Distributions

You cannot defer indefinitely. Required minimum distributions from a qualified annuity must begin by April 1 of the year after you turn 73.⁴ Starting in 2033, that age rises to 75 for individuals born in 1960 or later. If you are already receiving annuity payments that meet or exceed the minimum, those payments satisfy the RMD on their own.

Missing an RMD is expensive. The IRS imposes a 25% excise tax on the amount you should have taken. Catch the mistake and correct it within two years, and the penalty drops to 10%.⁴ Even the reduced penalty is high enough to justify a calendar reminder.

Non-Qualified Annuities: Only the Earnings Are Taxable

Non-qualified annuities are purchased with after-tax money. The IRS already taxed your original contributions, so the tax rules here are designed to prevent double taxation on those contributions while still collecting tax on the growth. How that split gets calculated depends entirely on how you take money out.

Annuitized Payments and the Exclusion Ratio

If you annuitize the contract, converting it into a stream of regular payments, each payment splits into two parts: a tax-free return of your original investment and a taxable portion representing earnings. The IRS uses a formula called the exclusion ratio to calculate the split. Divide your total investment in the contract by the expected return over the payment period, and the resulting percentage is the share of each payment that comes back tax-free.⁵

The ratio stays fixed until you have recovered your entire original investment. After that, every payment is fully taxable as ordinary income. Outlive the payout period used in the calculation and you keep receiving payments, but the tax-free component disappears.

Partial Withdrawals and the LIFO Rule

Random or partial withdrawals follow a less friendly rule. The IRS treats the first dollars coming out as the most recent earnings, not a return of your contributions. This last-in, first-out approach makes every withdrawal fully taxable until you have pulled out all the accumulated gains.⁶ Only after the earnings are gone do later withdrawals come from your tax-free principal.

A quick example. You put $80,000 into a non-qualified annuity that has grown to $100,000. Withdraw $25,000 and the first $20,000, the total earnings, is taxable income. The remaining $5,000 is a tax-free return of principal. That is the opposite of annuitization, where the two amounts blend into each payment.

Your insurance company will send you a Form 1099-R each year reporting the taxable and non-taxable portions of any distribution. You need it to file accurately.⁷

The 10% Early Withdrawal Penalty

Taking money out of an annuity before age 59½ triggers a 10% federal penalty tax on the taxable portion, on top of the ordinary income tax. For non-qualified annuities the rule sits in Section 72(q); for qualified retirement plan annuities, the parallel rule is Section 72(t).¹ The two subsections have slightly different exception lists.

For non-qualified annuities, the 10% penalty does not apply to distributions that are:

Made after the holder’s death. Beneficiary payouts are penalty-free regardless of the holder’s age at death.
Due to disability, as defined by the IRS (unable to engage in substantial gainful activity).
Part of a series of substantially equal periodic payments over your life expectancy, taken at least annually.
From an immediate annuity that begins paying income within one year of purchase.
Allocated to contributions made before August 14, 1982, which are grandfathered.

The substantially equal periodic payments exception is the most common route to funds before 59½. Once you start, though, you cannot change the amount or stop the payments until the later of five years or reaching age 59½. Modify the schedule before that date for any reason other than death or disability, and the IRS imposes a recapture tax equal to the 10% penalty you would have owed in every prior year, plus interest.⁸ That inflexibility is where most people run into trouble.

The 3.8% Net Investment Income Tax

Taxable gains from non-qualified annuities count as net investment income, which can add a 3.8% surtax on top of ordinary income tax. The Net Investment Income Tax applies when your modified adjusted gross income exceeds $200,000 for single filers, $250,000 for married couples filing jointly, or $125,000 for married filing separately.⁹ The tax is calculated on the lesser of your net investment income or the amount your income exceeds the threshold.

These thresholds are not indexed for inflation, so they catch more people every year. A large annuity withdrawal can push you over the line even if your regular income normally falls below it. Distributions from qualified annuities held inside retirement plans are generally not subject to the NIIT because they are classified as retirement plan income rather than investment income.

What Beneficiaries Owe on an Inherited Annuity

Annuity death benefits do not receive a stepped-up cost basis the way stocks or real estate do. The gains that built up during the original owner’s life stay taxable when a beneficiary receives them. The IRS classifies this as income in respect of a decedent, meaning the beneficiary pays the tax the original owner never did.¹⁰

Non-Qualified Annuities

Distribution rules for inherited non-qualified annuities come from Section 72(s), not the SECURE Act. If the owner dies before the contract starts paying out, the full value must generally be distributed within five years.¹ A named beneficiary can stretch payments over their own life expectancy instead, but only if distributions begin within one year of the owner’s death.

A surviving spouse gets the most favorable treatment. The law treats the spouse as the new holder of the contract, allowing tax-deferred growth to continue, distributions to be delayed, or annuitization on the spouse’s own schedule.¹ No other beneficiary has this option.

If the owner dies after payments have already started, the remaining payments must continue at least as quickly as the method in use at the time of death. The insurance company cannot slow the payout down.

Qualified Annuities

Qualified annuities inside retirement accounts follow the SECURE Act rather than Section 72(s). For deaths in 2020 or later, most non-spouse beneficiaries must empty the entire account within 10 years of the owner’s death.¹¹ Distributions do not have to be taken in any particular year within that window, but the full balance must be out by the end of the tenth.

A smaller group of eligible designated beneficiaries can still stretch distributions over their own life expectancy. This includes the surviving spouse, minor children of the account owner, disabled or chronically ill individuals, and beneficiaries who are not more than 10 years younger than the deceased owner.¹¹

Whichever rule applies, a large inherited payout can push a beneficiary into a higher tax bracket for the year. Spreading withdrawals across multiple tax years, when the rules allow it, can meaningfully cut the total federal tax owed.

Switching Annuities Without a Tax Bill

If you are unhappy with a current annuity’s fees or performance, federal law lets you swap it for a different contract without triggering immediate tax. Under Section 1035, you can exchange an annuity contract for another annuity, or for a qualified long-term care insurance policy, and defer all gains into the new contract.¹²

The exchange must be a direct transfer between insurance companies. If the money passes through your hands at any point, the IRS treats it as a taxable distribution. The new contract must also be owned by the same person as the original, and your cost basis carries over, so you are not resetting the clock on existing gains.

Partial 1035 exchanges are permitted but come with a 180-day holding rule. Take a withdrawal from either contract within 180 days of the transfer and the IRS can recharacterize the whole thing as a taxable distribution.¹³

A Warning for Trust and Business Ownership

An annuity owned by a corporation, trust, or other non-natural person generally loses tax-deferred status entirely. Under Section 72(u), the IRS does not treat such a contract as an annuity for tax purposes, and the income on the contract is taxed as ordinary income each year rather than deferred.¹ The rule exists to stop businesses from using annuities as a corporate tax shelter.

The biggest exception is the agent rule. If a trust holds an annuity as agent for a natural person, the IRS looks through to the individual beneficiary and deferral continues. A revocable living trust where you are both the grantor and the beneficiary typically qualifies. Irrevocable trusts are much harder to fit through the same doorway, and getting it wrong means losing tax deferral from the moment the trust takes ownership. Confirm the tax treatment before any transfer into a trust. Unwinding it afterward creates a taxable event.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 403 – Taxation of Employee Annuities
3
Internal Revenue Service. Federal Income Tax Rates and Brackets
4
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
5
Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
6
Internal Revenue Service. Publication 575 – Pension and Annuity Income
7
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
8
Internal Revenue Service. Substantially Equal Periodic Payments
9
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
10
Office of the Law Revision Counsel. 26 USC 691 – Recipients of Income in Respect of Decedents
11
Internal Revenue Service. Retirement Topics – Beneficiary
12
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
13
Internal Revenue Service. Revenue Procedure 2011-38