Annuity withdrawals are taxed differently depending on whether you are taking out money you already paid in or money the annuity earned
When you withdraw money from an annuity, the IRS treats the withdrawal in two parts: your basis (the money you contributed) and your earnings (the growth the annuity generated). Your basis comes out tax-free. Your earnings are taxed as ordinary income at your regular tax rate — the same rate as wages or interest. This is true whether the annuity is may have access to (held in a retirement account like an IRA) or non-may have access to (held outside a retirement account).
The tax treatment changes depending on when you withdraw and how old you are. If you withdraw before age 59½ from a non-may have access to annuity, you owe a 10 percent early withdrawal penalty on the earnings portion only — not on your basis. may have access to annuities (those inside an IRA or 401(k)) follow different rules: withdrawals before 59½ trigger the 10 percent penalty on the entire withdrawal amount, not just earnings. The order in which your money comes out also matters: non-may have access to annuities use a "last in, first out" rule for taxation purposes, meaning earnings come out first.
Key Takeaways
- Money you contributed to a non-may have access to annuity (your basis) withdraws tax-free; only the earnings portion is taxed as ordinary income.
- Withdrawals before age 59½ from a non-may have access to annuity trigger a 10 percent penalty only on earnings, not on your basis.
- may have access to annuities inside retirement accounts (IRAs, 401(k)s) tax the entire withdrawal as ordinary income, with a 10 percent early withdrawal penalty if you are under 59½.
- The IRS requires annuity companies to report non-may have access to annuity withdrawals on Form 1099-R, which shows how much is basis and how much is earnings.
How basis and earnings are separated on your tax forms
Your annuity company calculates your basis using a formula called the exclusion ratio. This ratio divides your total basis by the expected value of all payments you will receive over your lifetime (or the contract period, depending on the annuity type). The result is a percentage — for example, 40 percent of each withdrawal might be basis and 60 percent earnings.
The annuity company reports this breakdown on Form 1099-R, which you receive each year you take a withdrawal. Box 1 shows the total amount withdrawn. Box 2a shows how much of that is taxable (the earnings portion). You report this taxable amount on your tax return as ordinary income. Your basis — the non-taxable portion — is not reported to the IRS because you already paid tax on it when you contributed it.
If you withdraw your entire annuity in a single year, the exclusion ratio still applies to that lump sum. Once your basis is fully recovered (meaning you have withdrawn all the money you put in), every dollar you withdraw after that point is taxable earnings.
The 10 percent early withdrawal penalty and its exceptions
If you withdraw from a non-may have access to annuity before age 59½, the IRS charges a 10 percent penalty on the earnings portion only. This penalty is separate from income tax — you owe both. For example, if you withdraw $10,000 and $6,000 is earnings, you owe income tax on the $6,000 plus a $600 penalty (10 percent of $6,000).
may have access to annuities (those inside an IRA or 401(k)) work differently. The entire withdrawal is subject to the 10 percent penalty if you are under 59½, regardless of how much is basis versus earnings. This is because may have access to accounts already received a tax deduction when you contributed, so the IRS treats all withdrawals as taxable.
Several exceptions exist to the 10 percent penalty for both types of annuities. You can withdraw without penalty if you are disabled, if you are taking substantially equal periodic payments (called a 72(t) distribution for IRAs), if you are withdrawing to pay unreimbursed medical expenses above 7.5 percent of your adjusted gross income, or if you are withdrawing to pay health insurance premiums after losing your job. The rules for what counts as an exception differ between non-may have access to and may have access to annuities, so check with your annuity company or a tax professional about your specific situation.
Required minimum distributions and age 73
If your annuity is held inside a may have access to retirement account (IRA, 401(k), or similar), you must begin taking required minimum distributions (RMDs) at age 73, as of 2023. This age was raised from 72 by the find 2.0 Act. The IRS calculates your RMD using your age and account balance; you can find the calculation worksheet in IRS Publication 590-B.
RMDs are taxed as ordinary income, and they are not subject to the 10 percent early withdrawal penalty even if you are under 59½ (though you must be at least 59½ to avoid the penalty on other withdrawals). If you do not take your full RMD in a given year, the IRS charges a 25 percent penalty on the amount you failed to withdraw — reduced to 10 percent if you correct it within two years. This is one of the steepest penalties in the tax code, so RMDs should not be missed.
Annuities inside retirement accounts versus outside
A non-may have access to annuity is one you buy with after-tax money outside of any retirement account. A may have access to annuity sits inside an IRA, 401(k), 403(b), or similar plan. The tax treatment of withdrawals differs significantly.
| Feature | Non-may have access to Annuity | may have access to Annuity (IRA/401(k)) |
|---|---|---|
| Basis taxed on withdrawal | No — basis is tax-free | Yes — entire withdrawal is taxable |
| Earnings taxed on withdrawal | Yes — as ordinary income | Yes — as ordinary income |
| 10% penalty before 59½ | Applies to earnings only | Applies to entire withdrawal |
| Form reported on | Form 1099-R | Form 1099-R |
| RMD at age 73 | No RMD requirement | Yes, RMD required |
Non-may have access to annuities offer a tax advantage: you get your basis back tax-free. However, they do not offer the upfront tax deduction that may have access to accounts do. may have access to annuities let you deduct contributions (up to limits), but all withdrawals are taxable because you never paid tax on the money going in. The choice between the two depends on your income, retirement timeline, and whether you have already maxed out may have access to account contributions.
Annuity payouts and how they are taxed differently
If you convert your annuity into a stream of regular payments (called annuitization), the tax treatment is similar but calculated differently. Each payment you receive contains both basis and earnings. The annuity company calculates the exclusion ratio and applies it to every payment for life (or the contract period). This means a portion of each check is tax-free and a portion is taxable.
Once you have recovered your entire basis through these payments, all remaining payments are fully taxable. For a life annuity, this typically happens after a certain number of years, depending on your age and the annuity's terms. The IRS publishes life expectancy tables that the annuity company uses to calculate when your basis will be fully recovered.
Annuitized payments are reported on Form 1099-R just like lump-sum withdrawals. The taxable portion is ordinary income, and no 10 percent penalty applies to annuitized payments regardless of your age — the penalty only applies to non-annuitized withdrawals before 59½.
State taxes and how they explore to annuity withdrawals
Most states tax annuity withdrawals as ordinary income at your state income tax rate. A few states — including Pennsylvania, Tennessee, and Illinois — exempt certain types of retirement income from state tax, but the rules vary widely. Some states exempt only may have access to retirement account distributions, while others exempt non-may have access to annuity payments as well.
If you move to a different state after withdrawing from an annuity, you generally owe state tax in the state where you lived when you took the withdrawal, not where you live now. However, if you move to a state with no income tax (like Florida or Texas) after you retire, future withdrawals are not subject to state tax. Check your state's tax agency website or speak with a tax professional about your specific state's rules, as they change and vary by annuity type.
Frequently Asked Questions
Do I have to pay taxes on the money I already paid into the annuity?
No. The money you contributed (your basis) withdraws tax-free from a non-may have access to annuity. You already paid tax on it when you earned it. Only the earnings the annuity generated are taxed. may have access to annuities work differently — the entire withdrawal is taxable because you received a tax deduction when you contributed.
What happens if I withdraw before age 59½?
From a non-may have access to annuity, you owe a 10 percent penalty on the earnings portion only, plus income tax on those earnings. From a may have access to annuity, the 10 percent penalty applies to your entire withdrawal. Exceptions exist for disability, substantially equal periodic payments, and certain medical expenses.
How does the annuity company know how much of my withdrawal is basis versus earnings?
The company uses the exclusion ratio, which divides your total basis by the expected value of all payments you will receive. This percentage applies to every withdrawal until your basis is fully recovered. The company reports the taxable portion on Form 1099-R.
Do I owe taxes on annuity growth while the money is still in the account?
No. With a non-may have access to annuity, growth inside the account is tax-deferred — you owe tax only when you withdraw. With a may have access to annuity, growth is also tax-deferred. This tax deferral is one reason annuities are used for retirement savings.
What if I die before I withdraw all my annuity?
Your beneficiary inherits the remaining balance. They owe income tax on the earnings portion when they withdraw, but not on your basis. The tax treatment depends on whether the annuity is may have access to or non-may have access to and on the type of beneficiary (spouse, child, or other). Beneficiaries should speak with a tax professional about their specific situation.