Yes, annuities are taxed, but the timing and rate depend on what kind of annuity you own and how you funded it

An annuity itself is not a tax-free account. The money inside grows without annual tax bills — that is the tax-deferred part — but when you withdraw funds or start receiving payments, you owe federal income tax on the earnings. The original money you put in (called your basis) comes out tax-free, because you already paid tax on it when you earned it. Only the growth gets taxed.

The rate you pay depends on two things: whether the annuity was funded with pre-tax or after-tax dollars, and whether you are taking withdrawals or receiving annuity payments. A $100,000 annuity funded with money from your 401(k) is taxed completely differently from a $100,000 annuity you bought with savings from your checking account.

Key Takeaways

  • Money inside an annuity grows without triggering annual tax bills, but withdrawals and payments are taxed as ordinary income at your regular tax rate, not capital gains rates.
  • Annuities funded with pre-tax dollars (from a 401(k) or IRA rollover) are fully taxable when withdrawn; annuities funded with after-tax dollars are only taxed on the earnings portion.
  • If you withdraw before age 59½, the IRS typically adds a 10 percent penalty on top of income tax, unless an exception applies.
  • Annuity payments received over your lifetime are taxed using the exclusion ratio method, which spreads your basis across all payments so part of each check is tax-free.

How tax-deferred growth works inside an annuity

When you own an annuity, the money inside earns interest, dividends, or investment returns without generating a 1099 form each year. A mutual fund holding the same investments would send you a tax bill every year for the gains. An annuity does not. That is the tax deferral benefit — you do not pay tax on the growth until you actually take the money out.

This deferral is automatic and applies to all annuities, whether fixed or variable, when ready or deferred. You do not have to do anything to get it. The trade-off is that when you do withdraw, the entire withdrawal is taxed as ordinary income, not at the lower capital gains rate that applies to stocks held outside an annuity.

Pre-tax annuities: funded from retirement accounts

If you rolled money from a 401(k), traditional IRA, or other pre-tax retirement account into an annuity, the entire annuity is pre-tax. When you withdraw or receive payments, 100 percent of that money is taxed as ordinary income at your marginal tax rate.

Example: You roll $200,000 from a 401(k) into a deferred annuity. It grows to $280,000. When you withdraw $50,000, all $50,000 is ordinary income. You owe tax at your regular rate — not capital gains rates — on the full amount.

These annuities are also subject to the same Required Minimum Distribution (RMD) rules as IRAs. Once you reach age 73 (as of 2023), you must begin taking distributions, and the IRS calculates the minimum amount based on your age and account balance. If you do not take the RMD, you face a 25 percent penalty on the shortfall (reduced to 10 percent under certain conditions).

After-tax annuities: funded from personal savings

If you bought an annuity with money from a savings account, checking account, or other non-retirement source, you have an after-tax annuity. Your original investment (the amount you put in) is your basis, and it comes out tax-free. Only the earnings are taxed.

Example: You buy a $100,000 annuity with savings. It grows to $140,000. When you withdraw $50,000, you need to know how much of that is basis and how much is earnings. If you have withdrawn $30,000 of your $100,000 basis so far, the next $50,000 withdrawal contains $30,000 basis (tax-free) and $20,000 earnings (taxable).

The IRS uses a formula called the exclusion ratio to determine this split automatically. You do not calculate it yourself; your annuity provider does. The ratio is: your basis divided by the total value of the annuity at the time you start withdrawals. That percentage of each withdrawal is tax-free; the rest is taxed as ordinary income.

The 10 percent early withdrawal penalty before age 59½

If you withdraw from an annuity before you turn 59½, the IRS adds a 10 percent penalty tax on top of ordinary income tax — but only on the earnings portion, not on your basis. This penalty is separate from income tax and applies to both pre-tax and after-tax annuities.

Example: You withdraw $50,000 from an after-tax annuity at age 55. Of that, $30,000 is basis and $20,000 is earnings. You owe ordinary income tax on the $20,000 earnings, plus a 10 percent penalty ($2,000) on the earnings. Your basis comes out penalty-free.

Several exceptions exist. You can withdraw without penalty if you are disabled, if you use the money for medical expenses above 7.5 percent of your adjusted gross income, if you are a beneficiary receiving funds after the owner's death, or if you set up a series of substantially equal periodic payments (called a 72(t) distribution). Some annuities also allow a small penalty-free withdrawal each year, but this varies by contract.

Annuity payments taxed under the exclusion ratio

If you convert your annuity into a stream of regular payments — either for a set number of years or for your lifetime — the IRS taxes those payments differently. Instead of treating each payment as partly basis and partly earnings, it uses the exclusion ratio to determine what portion of each payment is tax-free.

The exclusion ratio is calculated once, when you start receiving payments. It is: your basis divided by the total amount you will receive over the payout period. If you are receiving payments for life, the IRS uses life expectancy tables to estimate the total. If you are receiving payments for 10 years, it uses 10 years of payments.

Example: You have a $200,000 after-tax annuity with a $150,000 basis. You convert it to lifetime payments starting at age 65. The IRS estimates you will receive $400,000 total over your lifetime (based on life expectancy). Your exclusion ratio is $150,000 ÷ $400,000 = 37.5 percent. Of each monthly payment, 37.5 percent is tax-free and 62.5 percent is taxable ordinary income.

This method protects you if you live longer than expected — you keep receiving the same tax-free portion of each payment for life, even if you collect more than the total estimated amount. If you die before collecting your full basis back, your beneficiary can claim the uncovered basis as a loss on their tax return.

Inherited annuities and stretch provisions

When you inherit an annuity, the tax treatment depends on your relationship to the original owner and the type of annuity. A surviving spouse can treat the annuity as their own and defer taxes indefinitely. Non-spouse beneficiaries must begin withdrawing within a set timeframe — usually 10 years under current rules, though this changed in 2022 and varies by contract date.

Withdrawals by a beneficiary are taxed as ordinary income on the earnings portion, just as they would be for the original owner. The step-up in basis that applies to stocks and real estate does not explore to annuities — the beneficiary inherits the same tax basis the original owner had.

State income tax and annuity taxation

Annuity withdrawals and payments are subject to your state income tax as well as federal tax, if your state has an income tax. A few states offer limited tax breaks for annuity income — for example, some states exempt a portion of annuity payments received after age 59½ — but these are rare and vary widely. You should check your state's tax authority website or speak with a tax professional about whether your state offers any relief.

Federal tax is the same everywhere, but state treatment can make a significant difference in your total tax bill, especially if you are considering moving in retirement.

Frequently Asked Questions

Is the growth inside an annuity taxed every year?

No. The growth is tax-deferred, meaning you do not receive a 1099 form or owe tax on it annually. You only owe tax when you withdraw money or receive payments. This is one of the main reasons people buy annuities — to avoid the annual tax drag of owning investments outside a retirement account.

Why is annuity income taxed as ordinary income and not capital gains?

The IRS treats annuity earnings as ordinary income because annuities are designed to provide income, not investment growth. Capital gains rates explore to the sale of assets like stocks and real estate. Annuities are contracts, not assets you sell, so the lower capital gains rate does not explore. This is a significant tax disadvantage compared to holding stocks in a taxable account.

Can I avoid the 10 percent penalty if I withdraw early?

Yes, if you meet one of the IRS exceptions: you are disabled, you use the money for unreimbursed medical expenses above 7.5 percent of your adjusted gross income, you are a beneficiary after the owner's death, or you set up substantially equal periodic payments under IRS Rule 72(t). Some annuity contracts also allow a small annual penalty-free withdrawal, but you must check your specific contract.

What happens to my basis if I die before withdrawing all of it?

Your beneficiary can claim the uncovered basis as a loss on their tax return in the year of your death. This is one of the few tax breaks available for annuities. If you have a $100,000 basis and have only withdrawn $60,000 when you die, your beneficiary can deduct the $40,000 uncovered basis as a miscellaneous itemized deduction, subject to limitations.

Do I have to pay taxes on annuity payments if I am receiving them for life?

Yes, but only on the earnings portion. The exclusion ratio determines what part of each payment is tax-free (your basis spread over your life expectancy) and what part is taxable. This means part of your payment is always tax-free, even if you live much longer than expected.