Blog
Taxing a non-qualified annuity withdrawal: gains come out first
A repeatable worksheet for the taxable part of each non-qualified annuity withdrawal, with a worked example, the 10% additional tax and records to keep.
When you take money out of a non-qualified deferred annuity, the tax rules generally treat the earnings as coming out first and your original after-tax premium as coming out last. That means the first dollars you withdraw are usually taxable, even though most of the account may be your own money. This post gives you a short worksheet that works out the taxable part of every withdrawal, a complete example with invented numbers, and a list of the records worth keeping.
The example is a hypothetical illustration of how the arithmetic works. It is not tax advice, and it leaves out growth, fees and state taxes to keep the numbers readable. For the wider picture of how annuities are taxed, the guide on how annuities are taxed is the place to start, and a tax professional can apply the rules to your return.
Who this worksheet is for
The worksheet applies to a non-qualified annuity: a deferred annuity you bought with money that had already been taxed, outside an IRA or employer plan. Your premiums are your cost basis, which the tax rules call your "investment in the contract." Growth above that is the gain, and it has not been taxed yet.
It does not apply to a qualified annuity held inside an IRA or a workplace plan. There the contributions were usually pre-tax, so there is typically no basis and every dollar withdrawn is generally taxable. The guide on Should you put an annuity in an IRA? covers that case. It also does not apply to payments after annuitization, which use a different method described in the exclusion ratio: how annuitized payments split into basis and gain.
The idea in one sentence
For a withdrawal from a deferred contract that has not been annuitized, the taxable part is generally the smaller of two numbers: the amount you withdrew, or the gain still sitting in the contract. Once the gain has been used up, further withdrawals are a tax-free return of your basis.
Gain, in this context, is simply the contract's value minus your basis. A contract worth $130,000 with $100,000 of basis holds $30,000 of gain.
The worksheet
Run these steps for each withdrawal, in date order. Keep going with the updated numbers for the next one.
- Contract value before the withdrawal (A).
- Basis before the withdrawal (B). This is the premiums you paid, less any basis already returned to you tax-free.
- Gain remaining (C) = A − B. If A is less than B, the gain is zero.
- Withdrawal amount (D).
- Taxable part (E) = the smaller of D and C.
- Tax-free part, a return of basis (F) = D − E.
- New contract value = A − D. New basis = B − F.
- Additional tax, if it applies: 10% × E, for an owner under 59½ with no exception. Details are in taking annuity money before 59½: when the 10 percent tax applies.
The tax on E is ordinary income tax at your rate, not capital gains tax. That is one reason the guide on how annuities are taxed describes tax deferral as a trade-off and not a free benefit.
A worked example
Say a hypothetical owner, Jordan, is 54 and holds a non-qualified deferred annuity. Jordan paid $100,000 of already-taxed money, and the contract is now worth $130,000. To keep the numbers clean, assume no growth, fees or surrender charges for the rest of the example. Jordan takes three withdrawals over a couple of years.
Withdrawal 1: $12,000.
- A = $130,000, B = $100,000, so C = $30,000 of gain.
- D = $12,000. The taxable part is the smaller of $12,000 and $30,000, so E = $12,000.
- F = $12,000 − $12,000 = $0 of basis returned.
- New value = $118,000. New basis = $100,000. Gain left = $18,000.
Withdrawal 2: $20,000.
- A = $118,000, B = $100,000, so C = $18,000.
- D = $20,000. The smaller of $20,000 and $18,000 is $18,000, so E = $18,000.
- F = $20,000 − $18,000 = $2,000 of basis returned.
- New value = $98,000. New basis = $100,000 − $2,000 = $98,000. Gain left = $0.
Withdrawal 3: $10,000.
- A = $98,000, B = $98,000, so C = $0.
- D = $10,000. The taxable part is the smaller of $10,000 and $0, so E = $0.
- F = $10,000, all of it return of basis.
- New value = $88,000. New basis = $88,000.
Here is the summary:
| Withdrawal | Amount | Taxable part | Tax-free part | Gain left afterward |
|---|---|---|---|---|
| 1 | $12,000 | $12,000 | $0 | $18,000 |
| 2 | $20,000 | $18,000 | $2,000 | $0 |
| 3 | $10,000 | $0 | $10,000 | $0 |
| Total | $42,000 | $30,000 | $12,000 |
Of the $42,000 Jordan took out, $30,000 was taxable and $12,000 was not. Every dollar of the gain was taxed, and the order is the reason. In the first two withdrawals, the gain came out ahead of the basis.
What the tax bill could look like
The tax depends on Jordan's income, filing status and state. To see the shape, assume an illustrative 22% federal rate on the $30,000 (a round number for illustration, not a statement about any particular bracket):
- Ordinary income tax: 22% × $30,000 = $6,600
- Additional 10% tax, because Jordan is 54 and no exception is assumed: 10% × $30,000 = $3,000
- Combined: $9,600 on $42,000 withdrawn, about 23%
Had Jordan been 60, the 10% additional tax would not apply, and the combined figure would be $6,600. In reality, federal brackets are graduated, so adding $30,000 of income may be taxed partly at one rate and partly at another. Higher earners may also owe the 3.8% net investment income tax on annuity gains in a non-qualified contract, and most states tax annuity income too. The only reliable number is the one a tax professional calculates from the actual return.
What a different order would have meant
The ordering rule is what makes the example surprising. If basis came out first, Jordan's $42,000 would have been tax-free until $100,000 had been returned. Under the gains-first rule, that favorable ordering is not available for a deferred contract. For a very old contract, where the premium was paid before August 14, 1982, different ordering rules apply to that early money, so a person who holds such a contract should check with a tax professional. For contracts bought since, gains come out first.
A second example: growth between withdrawals
The first example froze the contract's growth. Real contracts keep earning, and that refills the gain. Pick up Jordan's story after the first withdrawal, when the contract is worth $118,000 with $100,000 of basis and $18,000 of gain.
Say a year passes and the contract earns an illustrative 5%. The new value is $118,000 × 1.05 = $123,900, so the gain has grown to $23,900. Now Jordan takes a $20,000 withdrawal:
- C = $123,900 − $100,000 = $23,900.
- D = $20,000. The smaller of $20,000 and $23,900 is $20,000, so E = $20,000, all taxable.
- F = $0. New value = $103,900. New basis is still $100,000. Gain left = $3,900.
Compare this with the first example, where the same size of withdrawal at the same stage returned $2,000 of basis. The difference is growth: the gain was larger, so the entire withdrawal was taxable. A contract that is still growing quickly can keep every withdrawal fully taxable for years. The way a person escapes gains-first treatment is to withdraw more than the gain, which is only possible after the gain has been taken out.
A full surrender uses the same rule
Closing the contract is a withdrawal of everything, so the arithmetic is the same with D equal to the whole value. If Jordan had surrendered the original $130,000 contract in one step, the taxable part would be the smaller of $130,000 and $30,000, which is $30,000, and $100,000 would come back as basis. The total taxable amount is the same $30,000 as the three-step plan, because the gain is the gain. What differs is when it lands. A single surrender puts all $30,000 on one year's tax return. Withdrawals spread over several years put it on several returns, and the contract keeps growing, tax-deferred, in the meantime.
That difference can matter. Taxable income in one year can push some of the gain into a higher bracket than the same gain would face spread across two or three years. It can also affect other items tied to income, such as the taxable portion of Social Security benefits or Medicare premiums for people who are retired. These effects are why people ask a tax professional to model the timing before closing a large contract. They are also a reason to avoid concluding that spreading withdrawals is always better: if the money is needed now, or if later years are expected to carry higher income, the answer may differ.
How the worksheet fits with a surrender charge
A deferred annuity often carries a surrender charge in its early years. The charge and the gains-first rule are separate questions, and both can apply to the same withdrawal. The surrender charge decides how much cash reaches you. The tax rule decides how much of the withdrawal is taxable. Say Jordan's contract had a charge of 5% on any amount above a free amount. Jordan would still run the worksheet to find the taxable part, and then separately check what the insurer reports on the 1099-R. If you plan a withdrawal that could trigger a charge, get the insurer's quote for the net check and for the taxable amount in the same request.
Your own worksheet
Copy this table and fill it in with your own contract. Start with the most recent statement for A and your records for B.
| Step | Withdrawal 1 | Withdrawal 2 | Withdrawal 3 |
|---|---|---|---|
| A. Contract value before | ______ | ______ | ______ |
| B. Basis before | ______ | ______ | ______ |
| C. Gain remaining (A − B, or zero) | ______ | ______ | ______ |
| D. Withdrawal amount | ______ | ______ | ______ |
| E. Taxable part (smaller of C and D) | ______ | ______ | ______ |
| F. Tax-free part (D − E) | ______ | ______ | ______ |
| New value (A − D) | ______ | ______ | ______ |
| New basis (B − F) | ______ | ______ | ______ |
| 10% additional tax, if it applies (E × 10%) | ______ | ______ | ______ |
If growth continues between withdrawals, redo step A with the new value from your statement each time. The gain then rises even if you have withdrawn something, and the first part of the next withdrawal is taxable again.
Complications to watch for
The worksheet handles the plain case. Several real-world features change the inputs:
- More than one contract with the same company. Under the tax rules, non-qualified deferred annuities issued by the same insurer to the same owner in the same calendar year are generally treated as one contract for figuring gain. If you own several, ask the insurer or a tax professional how they combine.
- Loans, pledges and assignments. Borrowing against a non-qualified annuity or using it as collateral is generally treated as a withdrawal for tax purposes, so the gains-first rule applies.
- Gifts of a contract. Giving a contract to someone else can trigger tax on the gain, with some exceptions such as transfers between spouses. Check before transferring ownership.
- A 1035 exchanges: swapping policies without tax. A properly done exchange carries the basis and gain into the new contract. Keep the paperwork that shows how much of the new contract's value is basis.
- Surrender charges and fees. A surrender charge reduces what you receive. How the charge affects the reported taxable amount depends on the type of withdrawal, so ask the insurer how it will report it. The guide on annuity surrender charges and free withdrawals covers the charges.
- A contract worth less than your basis. If the value is below the premiums paid, there is no gain, and withdrawals come out as basis. A loss on a full surrender is treated differently from a gain, so a tax professional can advise.
- Withholding. Insurers generally withhold a default amount of federal tax from a non-periodic withdrawal unless you elect otherwise. The default may be less than you owe, so consider estimated payments.
Records to keep
The insurer reports distributions to you and the IRS on Form 1099-R, but you are the one who has to know your basis, and insurers' records can be incomplete, particularly after exchanges or ownership changes. Keep:
- Proof of every premium paid, such as the application, receipts and the first statement.
- Every Form 1099-R, which shows the gross amount, the taxable amount and a distribution code. Compare the taxable amount to your own worksheet each year.
- Annual statements, so you can see value and gain at each date.
- Exchange paperwork, if the contract came from a 1035 exchange, including the statement of basis carried over.
- Your running worksheet, updated after every withdrawal.
- A note of any exception you relied on for the additional tax, and the evidence for it.
If the taxable amount on a 1099-R does not match your worksheet, call the insurer before filing. A mismatch can come from a missing basis record or from an error on either side, and correcting it early is easier than answering a notice later.
When to get help
A short consultation with a tax professional is worth it if the withdrawal is large, if you are under 59½, if you own several annuities, if the contract came from an exchange or if the numbers on the 1099-R look wrong. The professional can also tell you whether withdrawing in a lower-income year would reduce the bill. Your state may tax annuity income in its own way, and the state revenue department or your tax preparer can say how.
Key takeaways
- For a non-qualified deferred annuity that has not been annuitized, withdrawals generally come out gains first, so the early withdrawals are taxable even though most of the balance is your own premium.
- The taxable part of each withdrawal is the smaller of the amount withdrawn and the gain left in the contract; once the gain is gone, the rest is a tax-free return of basis.
- The gain is taxed as ordinary income, and an owner under 59½ may owe an additional 10% tax on the taxable part unless an exception applies.
- Loans, collateral use and gifts of a contract can count as withdrawals, and several contracts from one insurer in one year can be combined for the calculation.
- Keep proof of premiums, every 1099-R and a running worksheet, because your basis is your responsibility to know.