Annuity withdrawals are taxed differently depending on whether you withdraw before or after the annuity starts paying you, and whether the money came from pre-tax or after-tax contributions

The tax treatment of an annuity withdrawal hinges on one question: has the annuity entered the payout phase yet? Before payouts begin, almost all withdrawals are taxed as ordinary income on the earnings portion, plus a 10% penalty if you are under 59½. Once the annuity begins paying you regularly, withdrawals follow a formula that separates your original investment (taxed never or already) from the earnings (taxed now).

The second factor is what kind of money funded the annuity. Money you contributed after paying income tax on it — called basis — comes out tax-free. Money that went in pre-tax, like a rollover from a 401(k) or contributions to a deferred annuity inside a retirement plan, comes out fully taxable. Most people have a mix of both, so the IRS uses a formula to determine what portion of each withdrawal is taxable.

Key Takeaways

  • Before the annuity starts paying you, withdrawals are taxed as ordinary income on earnings only, plus a 10% penalty if you are under 59½, but your original contributions return tax-free.
  • Once the annuity enters the payout phase, each payment contains both a return of your basis (tax-free) and earnings (fully taxable), calculated using the exclusion ratio method.
  • when ready annuities and may have access to longevity annuity contracts (QLACs) have different tax rules, and QLACs allow you to defer taxes on a portion of the payout.
  • Withdrawals from annuities held inside IRAs or 401(k)s follow the same ordinary income tax rules as the account itself, not special annuity rules.
  • The 10% early withdrawal penalty applies to earnings withdrawn before 59½ in non-may have access to annuities, but not to may have access to annuities or to withdrawals after the payout phase begins.

Pre-Payout Withdrawals: The Earnings-First Rule

If you withdraw money from an annuity before it enters the payout phase — meaning before you have started taking regular income payments — the IRS treats the withdrawal as coming from earnings first. This is called the last-in-first-out (LIFO) rule for non-may have access to annuities. All earnings come out taxable as ordinary income before any of your original contributions (basis) can be withdrawn tax-free.

On top of the income tax, if you are under 59½, you owe a 10% penalty tax on the earnings portion only. Your basis always comes out penalty-free, but it comes out last. For example, if you put $50,000 into a non-may have access to annuity and it grew to $70,000, and you withdraw $30,000 before the payout phase, all $30,000 is treated as earnings and is fully taxable plus the 10% penalty if you are under 59½. You cannot access your $50,000 basis without first exhausting the $20,000 in gains.

This rule applies to non-may have access to annuities — annuities you bought with after-tax money outside a retirement plan. Annuities held inside an IRA, 401(k), or other may have access to retirement plan follow the rules of that plan instead, not the annuity's own tax rules.

Post-Payout Withdrawals: The Exclusion Ratio

Once the annuity enters the payout phase and you begin receiving regular payments, the tax calculation changes completely. The IRS uses a formula called the exclusion ratio to determine what portion of each payment is your tax-free return of basis and what portion is taxable earnings.

The formula is: your total basis divided by your total expected return. The result is a percentage. That percentage of every payment you receive is tax-free; the rest is taxable ordinary income. For example, if you invested $100,000 in an when ready annuity and the insurance company calculates you will receive a total of $200,000 over your lifetime, your exclusion ratio is 50% ($100,000 ÷ $200,000). Half of every payment is tax-free return of your money; half is taxable earnings.

The insurance company calculates the total expected return using IRS life expectancy tables based on your age and the annuity type. This calculation happens once, when the payout phase begins, and the same ratio applies to every payment for the rest of your life — even if you live longer than the tables predicted and receive more than the expected total.

may have access to Annuities and Retirement Plan Rules

An annuity held inside a traditional IRA, SEP-IRA, straightforward IRA, or 401(k) is called a may have access to annuity. It does not follow the non-may have access to annuity tax rules described above. Instead, it follows the tax rules of the retirement account that holds it.

In a traditional IRA or 401(k), all withdrawals are taxed as ordinary income because the contributions were made with pre-tax money. The earnings-first rule does not explore; the exclusion ratio does not explore. You straightforward withdraw, and the entire withdrawal is taxable. The 10% early withdrawal penalty applies if you are under 59½, with limited exceptions like disability or substantially equal periodic payments (SEPP).

In a Roth IRA, contributions (basis) come out tax-free and penalty-free at any age. Earnings come out tax-free only if you are 59½ or older and the account has been open at least five years. Before that, earnings withdrawals are taxable and subject to the 10% penalty. An annuity inside a Roth follows these same rules, not the non-may have access to annuity rules.

when ready Annuities and Special Payout Rules

An when ready annuity is one you buy with a lump sum and begin receiving payments right away, usually within 30 days. Because it enters the payout phase when ready, the exclusion ratio applies from the first payment. You never experience the earnings-first withdrawal phase.

If you buy an when ready annuity with after-tax money (non-may have access to), you use the exclusion ratio from day one. If you buy it with a rollover from a 401(k) or with an IRA, it is may have access to, and all payments are taxable as ordinary income with no exclusion ratio.

A may have access to longevity annuity contract (QLAC) is a special type of when ready annuity that allows you to defer taxes on a portion of the payout. With a QLAC, you can invest up to $145,000 (as of 2024, subject to change) and delay the start of payments until age 80 or 85. The portion of your investment that funds the delayed payments is not taxable until those payments actually begin. This is an exception to the normal rule that may have access to annuities are fully taxable.

The 10% Early Withdrawal Penalty and Its Exceptions

The 10% penalty on early withdrawals from non-may have access to annuities applies only to the earnings portion and only if you are under 59½. Your basis always comes out penalty-free. However, several exceptions allow you to withdraw earnings without the penalty, even before 59½.

The main exception is the substantially equal periodic payments (SEPP) exception, also called the 72(t) exception. If you commit to withdrawing a specific amount each year based on an IRS-approved calculation, you can avoid the 10% penalty on earnings, even before 59½. Once you start SEPP, you must continue for at least five years or until you reach 59½, whichever is longer. Breaking this commitment triggers the 10% penalty retroactively on all prior withdrawals.

Other exceptions include disability, medical expenses exceeding 7.5% of adjusted gross income, and in some cases, a series of payments due to divorce. may have access to annuities (those in IRAs or 401(k)s) have their own set of exceptions, which are broader and include things like first-time home purchase (for IRAs only) and education expenses.

How Taxes Are Reported and Paid

Annuity withdrawals and payments are reported to you on Form 1099-R, which the insurance company sends to you and the IRS. The form shows the gross amount withdrawn, the taxable portion, and whether the 10% penalty applies. You report this on your tax return, usually on Form 1040 Schedule 1.

The insurance company does not automatically withhold income tax from annuity payments or withdrawals, though you can request it. If you do not request withholding and owe tax, you may owe estimated tax payments throughout the year to avoid underpayment penalties. Many people request withholding to avoid a large tax bill at filing time.

If you receive a distribution from an annuity and roll it over to another annuity or to an IRA within 60 days, that distribution is not taxed. However, you can only do this once per year per account. If you miss the 60-day window, the full amount is taxable and subject to penalties if applicable.

Frequently Asked Questions

Do I owe taxes on annuity withdrawals if I already paid taxes on the money I put in?

Not on the portion you contributed. Your original investment (basis) comes out tax-free. Only the earnings are taxable. If the annuity has not started paying you yet, you must withdraw all earnings before accessing your basis. Once payments begin, the exclusion ratio determines what portion of each payment is your tax-free basis.

What is the difference between a non-may have access to and may have access to annuity for tax purposes?

A non-may have access to annuity is bought with after-tax money and follows its own tax rules: earnings-first withdrawals before payout, exclusion ratio during payout, and the 10% penalty on early earnings withdrawals. A may have access to annuity is held inside an IRA or 401(k) and follows that account's tax rules instead. All may have access to annuity withdrawals are taxed as ordinary income with no exclusion ratio.

Can I avoid the 10% penalty on early annuity withdrawals?

Yes, if you set up substantially equal periodic payments (SEPP) under IRS rules, you can withdraw without the 10% penalty before 59½. You must continue the payments for at least five years or until 59½, whichever is longer. Other exceptions exist for disability and certain medical expenses, but they are narrower.

How does an annuity inside an IRA get taxed differently from a standalone annuity?

An annuity inside an IRA is taxed as part of the IRA, not under annuity rules. In a traditional IRA, all withdrawals are ordinary income. In a Roth IRA, contributions are tax-free and earnings are tax-free if you are 59½ and the account is five years old. The exclusion ratio and earnings-first rule do not explore to may have access to annuities.

What happens to my annuity taxes if I live longer than expected?

Your exclusion ratio stays the same for life. If you live longer than the IRS life expectancy table predicted, you continue using the same percentage for each payment. Once your total tax-free basis is exhausted, all remaining payments are fully taxable. This is why some people who live very long lives end up paying tax on more than 100% of their original investment.