How annuities are taxed

Annuity earnings are not taxed while they stay inside the contract, but they are taxed as ordinary income (not capital gains) when you take them out. How much of each payment is taxable depends on whether the annuity was bought with after-tax money (non-qualified) or with pre-tax retirement money (qualified), and on whether you take withdrawals or convert to a stream of payments.

Qualified vs non-qualified

• Qualified annuity. Held inside an IRA, 401(k), 403(b) or similar plan. Contributions were usually deducted or excluded, so there is typically no cost basis and every dollar withdrawn is taxable. The annuity adds no extra tax deferral, because the account already has it. Required distributions apply (see Should you put an annuity in an IRA?).
• Non-qualified annuity. Bought with money you already paid tax on. Your premiums are your basis and come back tax-free; only the earnings are taxable.

Withdrawals vs annuitized payments

How a non-qualified annuity is taxed depends on how you take the money, as described in IRS Publication 575 and Publication 939.

The earnings-first rule for withdrawals is a major trap. Say a hypothetical retiree put $100,000 into a deferred annuity that is now worth $140,000 and withdraws $20,000. The whole $20,000 is taxable because it comes out of the $40,000 of earnings first. The same $20,000 from an annuitized stream would be taxed in part, using the exclusion ratio.

A worked exclusion-ratio example

Say a hypothetical 70-year-old pays $100,000 of after-tax money for an immediate annuity that pays $600 a month for life, and the insurer calculates an expected return of $150,000 based on life expectancy tables. The exclusion ratio is $100,000 divided by $150,000, or about 66.7%. Each $600 payment then has roughly $400 of tax-free return of basis and $200 of taxable income. Once the retiree has recovered the full $100,000, the entire $600 becomes taxable. The insurer usually reports the taxable portion for you on Form 1099-R, and the annuity payout calculator shows the payment side of this arithmetic. These figures are for illustration only, not quotes.

Why the tax treatment matters when you choose

Tax deferral is useful but not free. You give up capital gains rates and the step-up in basis at death that you would get on stocks held in a taxable account, in exchange for deferral and, with an income annuity, a spread-out tax bill. That trade is why many planners suggest first filling IRAs and 401(k)s before using a non-qualified deferred annuity for tax deferral. The question of whether the product suits you at all is covered in are annuities a good idea?.

Early withdrawals: the 10% additional tax

Under IRS Topic 410, taking payments before age 59 1/2 can bring an additional 10% tax on the taxable part, unless an exception applies. The listed exceptions include substantially equal periodic payments, disability and distributions after death. Qualified accounts have their own exceptions, so check the specific plan or IRA rules.

Other taxes to know

• Net investment income tax. Gains in a non-qualified annuity can be subject to the 3.8% tax for higher earners; the IRS describes annuities as covered when they are non-qualified. Qualified annuity distributions are not part of that tax base.
• State tax. Most states tax annuity income, though some exempt pension or retirement income. Check your state's rules.
• Premium tax. Some states tax annuity premiums, which the insurer typically deducts. The NAIC chart lists 0% for annuities in many states.
• Reporting. The insurer reports distributions on Form 1099-R.

Special cases

• Exchanges. Swapping one annuity for another, or a life insurance policy into an annuity, can be tax-free under 26 U.S.C. section 1035. Annuity to life insurance is not allowed. See 1035 exchanges: swapping policies without tax.
• Deferral in a QLAC. Money used for a qualified longevity annuity contracts stays out of RMD calculations until payments start.
• Heirs. Gains are taxable to a beneficiary, with no step-up in basis. Non-qualified annuities follow the section 72(s) timing rules, and qualified ones generally follow the SECURE Act 10-year rule for most non-spouse beneficiaries. The detail is in annuity beneficiaries and inherited annuity options.
• Variable annuity gains. They are ordinary income, even if the subaccounts earned what would have been long-term capital gains in a taxable account. That difference can matter if you have already used your IRA and 401(k) room.

Steps to plan the tax

1. Identify whether the contract is qualified or non-qualified, and find your basis on past statements or Form 1099-R.
2. Before withdrawing, ask the insurer for the taxable portion, any surrender charge and withholding.
3. If you are under 59 1/2, check for an exception before touching the money.
4. If you have a choice, compare a lump sum, partial withdrawals and annuitization, since the exclusion ratio spreads tax over time.
5. Have a tax professional run the numbers if a large withdrawal could push you into a higher bracket or affect Medicare premiums.

Key takeaways

• Annuity growth is tax-deferred, but gains are taxed as ordinary income when withdrawn, not as capital gains.
• On non-qualified annuities, withdrawals come out earnings-first; annuitized payments use an exclusion ratio to return basis tax-free over time.
• Qualified (IRA or plan) annuities usually have no basis, so every dollar is taxable and RMDs apply.
• Taking money before age 59 1/2 can add a 10% additional tax unless an exception applies.
• Beneficiaries pay tax on the gain and receive no basis step-up.