Annuity tax myths: deferral, step-up basis and tax-free pitches

Annuity sales conversations are full of tax statements that are half true: accurate in one narrow setting and misleading in the setting you are actually in. "Your money grows tax-deferred" is true. "So you avoid tax" is not. "Heirs get a step-up in basis" is true for stock and false for annuity gain. This post takes ten of the most common statements and tests each one against how the contract and the tax rules really work, then gives the nuance that decides whether the statement helps or hurts you.

The rules described are general federal rules as of 2026, and states add their own. For your own situation, a tax professional who has the contract in front of them is the right person to ask. The structure of the tests is the same for each myth: the claim, how the mechanism works, and what is left standing.

Myths about deferral

Myth 1: "An annuity lets you avoid tax on your growth"

The claim. Because interest and investment gains inside an annuity are not taxed each year, the pitch goes, the money escapes tax.

The test. Deferral postpones tax; it does not remove it. The earnings in a non-qualified annuity, one bought with after-tax money, are taxed as ordinary income when they come out, and the insurer reports the taxable part on Form 1099-R. What you gain is time. Money that would have been taxed every year stays invested, so it compounds on a larger base. What you give up is the lower tax rates on long-term capital gains and qualified dividends that a taxable investment account can offer, and the stepped-up basis at death, discussed below.

The nuance. Whether deferral wins depends on how long the money stays put, the tax rate when it comes out compared with the rate you would have paid along the way, and what the annuity costs. The guide on how annuities are taxed sets out the mechanics, and Does tax deferral pay for an annuity's costs? A break-even worksheet builds a break-even worksheet.

Here is a hypothetical to show the size of the effect. Say $100,000 earns an illustrative 5 percent a year for ten years, with no withdrawals in between and a 24 percent ordinary income tax rate applied at the end.

• Value after ten years: $100,000 × 1.05^10 ≈ $162,889.
• Gain: $162,889 − $100,000 = $62,889.
• Tax on the gain at 24 percent: about $15,093.
• After-tax value of the annuity with no fees: about $147,796.

Now put the same money in a taxable account that earns the same 5 percent, is never sold until the end, and is taxed at an illustrative 15 percent capital gains rate when sold: $162,889 − (15% × $62,889) ≈ $153,456. In this simple setup the taxable account ends ahead, because the lower rate on the gain outweighs the benefit of deferral. Change the assumptions, for example by taxing the taxable account's dividends each year, and the order can reverse. The point is that deferral is a benefit with a price, not a free pass. All of these figures are illustrations with invented rates.

Myth 2: "Deferral always beats a taxable account"

The claim. Tax-deferred is better than taxable, full stop.

The test. Add the annuity's costs. Variable annuities in particular can carry charges for mortality and expenses, administration, investment management and optional riders; the guide on annuity fees, explained lists them. Continue the example above with an annual total charge of 1 percent, so the net growth is 4 percent: $100,000 × 1.04^10 ≈ $148,024. The gain is $48,024, tax at 24 percent is about $11,526 and the after-tax value is about $136,499. That is roughly $17,000 below the taxable account in the previous example.

The nuance. Fees are only part of it. A fixed annuity with no explicit annual fee builds its costs into the crediting rate, so the comparison is between the rate credited and the rate available elsewhere. Deferral works best when the holding period is long, the investments inside would have produced a lot of taxable income each year, and the owner expects to be in a lower bracket later. It works worst in the reverse conditions. Neither answer is built into the product.

Myth 3: "An annuity inside my IRA gives me extra tax benefits"

The claim. Putting an annuity in an IRA adds tax deferral on top of the IRA's own deferral.

The test. A traditional IRA already defers tax on everything inside it. An annuity placed in the IRA adds no further deferral, because there was none left to add. It can still provide features, such as a guaranteed lifetime income or a death benefit, and those features have costs. The question is whether the features are worth the price, not whether the tax treatment improves. A qualified annuity also has no after-tax basis in most cases, so every dollar that comes out is taxable, and required minimum distribution rules apply once the owner reaches the required age: 73 under current law, rising to 75 for those born in 1960 or later. The guide on Should you put an annuity in an IRA? covers the choice.

The nuance. Some people put an annuity in an IRA because the money is already in an IRA and the product has a feature they want. That is a product decision, and it is a legitimate one. The error is believing the wrapper is also a tax benefit.

Myths about how money comes out

Myth 4: "Withdrawals come out of your principal first, so they are mostly tax-free"

The claim. You paid $100,000, so the first $100,000 you take out is your own money coming back, and only later withdrawals are taxed.

The test. For a non-qualified annuity that has not been converted into payments, withdrawals are generally treated as earnings first. Everything up to the amount of the gain is taxable, and only after the earnings are exhausted does the tax-free return of cost basis begin. (This is the opposite of how life insurance cash value is usually treated when you withdraw, which is why people confuse them. A contract that counts as a modified endowment contract is also taxed gains-first.) Say a contract is worth $140,000 with a basis of $100,000, so it holds $40,000 of earnings. A withdrawal of $20,000 is fully taxable. A withdrawal of $50,000 is taxable for the first $40,000, and the remaining $10,000 is a tax-free return of basis. A more detailed look is in taxing a non-qualified annuity withdrawal: gains come out first.

The nuance. An important exception arises with older contracts: money put in before August 14, 1982, is treated under older rules that allow basis to come out first. Most readers will not own such a contract, and the insurer or a tax professional can say whether one does. For nearly everyone else, assume earnings first.

Myth 5: "Payout annuity income is mostly tax-free"

The claim. Because part of each payment is a return of your own money, income from an annuity is largely tax-free.

The test. This one is half right, which is why it persists. When a non-qualified annuity is converted into a stream of payments (annuitization), each payment is split into a tax-free part and a taxable part by the exclusion ratio: your investment divided by the expected total of payments. Say a hypothetical 70-year-old pays $100,000 of after-tax money for a lifetime annuity paying $600 a month, and the expected return is $150,000. The ratio is $100,000 ÷ $150,000, about 66.7 percent. Each $600 payment has about $400 excluded and $200 taxable. The statement is true, at first.

Then it stops being true. Once the total of the excluded amounts equals the original investment, the exclusion ends and every later payment is fully taxable. In this example $100,000 ÷ $400 = 250 payments, a little under 21 years. A person who lives past that point pays tax on the whole check from then on. And if the annuity sits inside an IRA or employer plan, there is generally no basis at all, so every payment is taxable from the first. The worked mechanics are in the exclusion ratio: how annuitized payments split into basis and gain.

The nuance. The exclusion ratio spreads tax over the payout years, which can keep a retiree in a lower bracket than a lump sum would. That benefit is real. Calling the income "tax-free" is not.

Myth 6: "Annuity gains are taxed as capital gains"

The claim. The gain is a gain, so it gets the lower rates.

The test. Annuity earnings are taxed as ordinary income, at the same rates as wages, whether the underlying investments inside a variable annuity earned long-term capital gains or not. Qualified dividends and long-term gains lose their special rates the moment they are earned inside the wrapper. For some higher-income owners, non-qualified annuity gains can also be part of the base for the net investment income tax. A tax professional can tell you whether that applies to you.

The nuance. If the choice is between an annuity and a taxable account holding stock for the long term, this difference is one of the main costs of using the annuity for tax purposes alone.

Myths about death and heirs

Myth 7: "My heirs get a step-up in basis"

The claim. At death, the cost basis resets to current value, so the heirs owe nothing on the gain.

The test. A step-up in basis is real for many inherited assets, such as stock or real estate held in a taxable account. It does not work that way for annuity gain. The gain in an annuity is income the owner never reported, and the beneficiary who receives it pays ordinary income tax on it as it is paid out. Say an annuity is worth $200,000 at death and the owner's basis was $120,000. The beneficiary receives $200,000 and owes ordinary tax on the $80,000 of gain. At an illustrative 24 percent, that is $19,200. If the same $200,000 had been stock with a $120,000 original cost, the heir's basis would reset to about $200,000 and a prompt sale would produce little or no taxable gain.

The nuance. A surviving spouse can generally continue the contract as the new owner, which defers the tax again; see a spouse inherits an annuity: continue it, cash out or take payments. Non-spouse heirs face payout timing rules on top of the tax, covered in annuity beneficiaries and inherited annuity options. An owner who wants to leave money to heirs has to weigh these costs, because other assets pass with a better tax result. Some owners draw the gain down during life, or give assets to heirs in other forms, for exactly this reason. Estate-planning specifics belong with an attorney.

Myth 8: "An annuity death benefit is tax-free like life insurance"

The claim. Insurance companies pay it, so it is treated like a life insurance payout.

The test. Life insurance proceeds paid to a named beneficiary are generally free of income tax. An annuity death benefit is a different thing: the beneficiary owes ordinary income tax on the part that exceeds the owner's basis, and on all of it if the annuity was held in a retirement account. See what happens to an annuity when you die for the contract side.

The nuance. Both can be included in the owner's taxable estate when the owner held them, though the 2026 federal exclusion of $15,000,000 per person means most estates owe no federal estate tax. Income tax and estate tax are separate questions.

Myths about "tax-free" pitches

Myth 9: "You can get tax-free retirement income from an annuity"

The claim. A presentation promises tax-free income in retirement, and an annuity is on the page.

The test. Ask which account the annuity sits in. Inside a traditional IRA or a non-qualified contract, the income is taxable in whole or in part. Inside a Roth IRA, qualified distributions can be tax-free, but the Roth wrapper provides that, not the annuity, and the rules about age and holding period apply. When the pitch describes a life insurance policy and its loans, a different set of rules applies, covered in IUL vs Roth IRA for tax-free retirement income. Loans against a policy are generally not taxed while the policy stays in force and is not a modified endowment contract, and a lapse with a loan outstanding can create taxable income. That is a life insurance feature, not an annuity one.

The nuance. "Tax-free" often means "tax-deferred until later" or "tax-advantaged compared with something else." Ask the presenter which tax code section creates the benefit.

Myth 10: "A 1035 exchange makes the gain disappear"

The claim. Swapping to a new annuity wipes out the tax bill.

The test. A section 1035 exchange moves a contract to a new one without immediate tax on the gain. The gain and the basis move with it, and the tax comes later when money is withdrawn. Taxable cash received during the swap, and any loan relief, are taxed. The exchange also does not avoid a surrender charge on the old contract, and the new contract may start a new surrender period. See 1035 exchanges: swapping policies without tax for the rules and the risks, including the fact that replacement can be driven by a new commission.

The nuance. An exchange is useful when the new contract is better for reasons that have nothing to do with tax. When the pitch is that the exchange saves tax, check whether the tax was simply moved.

Checking a tax claim yourself

When you hear a tax statement about an annuity, five questions usually sort it out.

1. Is the contract qualified or non-qualified, and what is the basis?
2. Is the money being withdrawn, or has the contract been converted to payments?
3. What is my age, and is a 10 percent additional tax possible before 59½?
4. Who gets what at death, and does the gain pass with or without a basis reset?
5. What does the contract charge for the deferral, and what would the same money do in a taxable account?

Write the answers next to the claim. If the presenter cannot answer in writing, or the answer depends on a number the presenter will not show, treat that as information too. Insurers and agents are required to follow best-interest and suitability rules in many states, and a state insurance department takes complaints about misleading sales material.

Key takeaways

• Deferral delays tax on annuity gains; it does not remove it, and the gain is taxed as ordinary income, not at capital gains rates.
• Withdrawals from a non-qualified deferred annuity come out gains first, while annuitized payments use an exclusion ratio that ends once your basis is recovered.
• Heirs get no step-up in basis on annuity gain, so a beneficiary pays ordinary income tax on it, unlike on many other inherited assets.
• Whether deferral wins depends on holding period, tax rates and fees. In the hypothetical, a 1 percent annual charge cut the final value by about $11,300.
• "Tax-free" almost always comes from a different wrapper, such as a Roth IRA or a life insurance policy, not from the annuity itself.