The tax on an annuitized distribution depends entirely on what kind of money funded the contract. If you annuitized a traditional IRA, 401(k), or other pre-tax retirement account, every dollar of every payment is taxed as ordinary income at your marginal rate. If you annuitized a non-qualified contract bought with after-tax dollars, only the earnings portion of each payment is taxable; the rest is a tax-free return of the money you originally put in, calculated using an exclusion ratio set at the start of payments. Roth-funded annuity payments can come out entirely tax-free once the standard Roth conditions are met.
The three funding sources produce three different results, and the difference is worth thousands of dollars a year for anyone taking meaningful payments. Here is what applies in each case.
Qualified Annuities: Every Payment Is Ordinary Income
An annuity held inside a traditional IRA, 401(k), 403(b), or similar qualified plan was funded with pre-tax dollars, or grew entirely tax-deferred, or both. You never paid income tax on that money going in, so the IRS collects on the way out. Every dollar of every payment is taxable as ordinary income at your marginal rate.1Internal Revenue Service. Publication 575 – Pension and Annuity Income There is no tax-free portion because there is no after-tax principal to return.
One narrow exception applies. If you made nondeductible contributions to a traditional IRA, those contributions created a small cost basis, and that basis is recovered tax-free over the payment period using the Simplified Method in IRS Publication 575.1Internal Revenue Service. Publication 575 – Pension and Annuity Income Most people with qualified annuities owe tax on the full payment.
The insurer or plan administrator reports what you received each year on Form 1099-R.2Internal Revenue Service. About Form 1099-R
Non-Qualified Annuities and the Exclusion Ratio
A non-qualified annuity is one you bought with money that had already been taxed. Because the IRS will not tax the same dollar twice, you get your original investment back over the payment period without paying income tax on it. Only the growth is taxed.
The split between the two happens through the exclusion ratio in Internal Revenue Code Section 72(b). You divide your investment in the contract (total premiums paid) by the expected return (total payments the insurer projects you will receive).3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The resulting percentage of each payment is your tax-free return of principal, and it stays the same for the life of the payments.4eCFR. 26 CFR 1.72-4 – Exclusion Ratio
A quick example. You paid $100,000 in premiums and the insurer expects to pay you $200,000 over your lifetime. Your exclusion ratio is 50%. On a $1,000 monthly payment, $500 is a tax-free return of your investment and $500 is taxable as ordinary income. That split holds until you have recovered the entire $100,000 basis.
Once your full cost basis has been returned, the exclusion ratio no longer applies. Every payment after that point is fully taxable as ordinary income.1Internal Revenue Service. Publication 575 – Pension and Annuity Income Someone who lives well beyond the actuarial expectation ends up in effectively the same tax posture as a qualified annuity holder.
Partial Annuitization
You are not required to annuitize the whole contract at once. Under Section 72(a)(2), if you annuitize part of a non-qualified contract for at least 10 years or for life, the IRS treats the annuitized portion as a separate contract with its own exclusion ratio.5Internal Revenue Service. Revenue Procedure 2011-38 Your investment in the contract is allocated pro rata between the annuitized portion and the portion that stays in accumulation. Each half is taxed on its own terms.
Withdrawals Before Annuitization: The Earnings-First Rule
The exclusion ratio only kicks in once you actually annuitize. Money you pull out of a non-qualified contract while it is still in the accumulation phase follows a much less favorable rule.
Under Section 72(e), the IRS treats earnings as coming out first. Each withdrawal is fully taxable as ordinary income until every dollar of accumulated growth has been withdrawn. Only after the earnings are exhausted can you touch your original after-tax principal tax-free.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The practical difference is large. Annuitizing spreads the tax-free basis across every future payment. Taking pre-annuitization withdrawals stacks the taxable earnings up front and delays any tax-free treatment until the account has been substantially drawn down. If you plan to draw from a non-qualified contract without annuitizing, expect the early years to be fully taxable.
Roth Annuity Distributions
An annuity held inside a Roth IRA or Roth 401(k) sits in a different regime. Qualified distributions from a Roth are entirely free of federal income tax. A distribution is qualified once you have held the Roth account for at least five years and you are at least 59½, disabled, or taking the distribution as a beneficiary after the owner’s death.
When those conditions are met, Roth annuity payments produce no taxable income at all. They are also excluded from net investment income for the surtax discussed next.6Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
The 3.8% Net Investment Income Tax
Higher-income taxpayers face an extra 3.8% surtax on net investment income when modified adjusted gross income exceeds $200,000 for a single filer or $250,000 for a joint filer. The taxable portion of non-qualified annuity distributions counts as net investment income and gets hit with this surtax on top of ordinary income tax.7eCFR. 26 CFR 1.1411-4 – Definition of Net Investment Income
Distributions from qualified plans, including traditional IRAs, 401(k)s, 403(b)s, and Roth IRAs, are not net investment income and are exempt.6Internal Revenue Service. Questions and Answers on the Net Investment Income Tax For a retiree with a large non-qualified annuity, the effective rate on the earnings portion is your marginal rate plus 3.8%. It is easy to miss in a retirement income projection that focuses only on the income tax bracket.
What Beneficiaries Owe After the Annuitant Dies
Annuities do not get the step-up in cost basis that stocks and real estate often receive at death. The earnings portion of whatever remains keeps its character as ordinary income and gets taxed to the beneficiary.
How fast the bill comes due depends on how the beneficiary takes the money. If payments continue under a life annuity with a refund feature or a period-certain guarantee, the beneficiary keeps excluding a portion of each payment from income until the total tax-free amount received by both the original annuitant and the beneficiary equals the investment in the contract. After that point every payment is fully taxable.1Internal Revenue Service. Publication 575 – Pension and Annuity Income A beneficiary who takes a lump-sum surrender instead pays tax on all accumulated earnings in a single year, which can push them into a higher bracket. Spreading the money out over time usually produces a smaller total tax bill.
For qualified annuities, the entire distribution to a beneficiary is ordinary income regardless of payout method, because there is no after-tax basis to recover. Spousal beneficiaries generally have more options, including rolling the annuity into their own IRA and continuing to defer tax.
Switching Contracts Without Triggering Tax: Section 1035
If you want out of your current annuity but do not want a tax hit, Section 1035 of the Internal Revenue Code lets you exchange one annuity contract for another without recognizing any gain.8Internal Revenue Service. Revenue Ruling 2007-24 – Section 1035 Exchanges of Insurance Policies The transfer has to go directly between insurance companies. If the old insurer writes you a check and you endorse it to the new company, the exchange fails and the entire gain becomes taxable in that year.
A valid 1035 exchange carries your original cost basis into the new contract, which preserves your future exclusion ratio when you eventually annuitize. Look carefully at any remaining surrender charge on the old contract and the new surrender period on the replacement before pulling the trigger; a tax-free exchange is not a bargain if the fees on both ends outweigh what you gain by moving.
Putting the Pieces Together
Three questions decide what you owe on any given annuity payment. Was the contract funded with pre-tax, after-tax, or Roth money? Have you formally annuitized, or are you still taking withdrawals from the accumulation phase? And does your income push you into the 3.8% surtax range on top of ordinary income tax?
Pre-tax funding means the whole payment is taxable. After-tax funding means a fixed percentage of each payment is a tax-free return of basis until the basis runs out, after which the whole payment becomes taxable. Roth funding means nothing is taxed once the standard Roth rules are satisfied. The surtax adds 3.8% to the taxable portion of non-qualified payments for higher earners and leaves qualified and Roth payments alone. Beneficiaries inherit the same character of income the original owner would have faced, without the reset that other inherited assets sometimes get.