Tax on annuity withdrawals depends on whether your contributions were pre-tax or after-tax
The tax you owe on an annuity withdrawal falls into two categories: ordinary income tax on the earnings portion, and possibly no tax on the portion that came from your own contributions. If you funded the annuity with pre-tax dollars (through an employer plan or traditional IRA), the entire withdrawal is taxed as ordinary income at your regular tax rate. If you funded it with after-tax dollars, only the earnings are taxed; your contributions come out tax-free.
The IRS calls this the exclusion ratio. It is the percentage of each withdrawal that represents your own money versus the insurance company's earnings. You calculate it once when you start taking withdrawals, and it stays the same for the life of the annuity.
Withdrawals before age 59½ may also trigger a 10 percent early withdrawal penalty on the taxable portion, with limited exceptions. This penalty applies whether the annuity is inside or outside a retirement account.
Key Takeaways
- Pre-tax annuities (funded with employer contributions or traditional IRA money) are fully taxable as ordinary income when withdrawn.
- After-tax annuities (funded with your own money) use an exclusion ratio so only earnings are taxed, not your contributions.
- Withdrawals before age 59½ face a 10 percent penalty on the taxable portion unless you meet a narrow exception.
- You report annuity income on Form 1040 and may need Form 8949 or Schedule D if you have capital gains or losses.
- The tax treatment changes if you annuitize (convert to a may provide income stream) versus taking random withdrawals.
How the exclusion ratio works for after-tax annuities
If you bought an annuity with money you already paid income tax on, the IRS lets you recover that money tax-free. To find your exclusion ratio, divide your total contribution (the amount you put in) by the expected return (what the insurance company projects you will receive over your lifetime). Multiply by 100 to get a percentage.
Example: You invested $100,000 in an after-tax annuity. The insurance company calculates your expected return at $250,000 over your life expectancy. Your exclusion ratio is $100,000 ÷ $250,000 = 40 percent. Each withdrawal is 40 percent tax-free return of contribution, and 60 percent taxable earnings.
The insurance company provides this calculation on Form 1099-R when you start withdrawals. You do not calculate it yourself. The exclusion ratio stays the same for the entire life of the annuity, even if you live longer than the company projected.
Pre-tax annuities and full ordinary income taxation
An annuity funded through a 401(k), 403(b), traditional IRA, or other pre-tax retirement plan is treated as pre-tax money. Every dollar you withdraw is taxed as ordinary income at your marginal tax rate for that year. There is no exclusion ratio because none of your contributions were after-tax.
This applies even if you rolled the annuity from one retirement account to another. The tax status follows the money, not the annuity contract itself.
If you withdraw $10,000 from a pre-tax annuity and you are in the 22 percent tax bracket, you owe $2,200 in federal income tax on that withdrawal. State income tax may explore as well, depending on where you live.
The 10 percent early withdrawal penalty before age 59½
If you withdraw money from an annuity before you turn 59½, the IRS adds a 10 percent penalty tax on top of ordinary income tax. This penalty applies to the taxable portion only. For after-tax annuities, the penalty hits only the earnings portion (the 60 percent in the example above). For pre-tax annuities, the penalty applies to the entire withdrawal.
The penalty is separate from income tax. If you withdraw $10,000 from a pre-tax annuity at age 50, you owe both the ordinary income tax (22 percent = $2,200 in this example) and the 10 percent penalty ($1,000), for a total of $3,200 in federal tax alone.
Exceptions to the 10 percent penalty exist but are narrow. You avoid the penalty if you are 59½ or older, if you are disabled, if you are a beneficiary receiving money after the owner's death, or if you take substantially equal periodic payments (SEPP) under IRS rules. SEPP requires you to take the same amount every year for at least five years or until age 59½, whichever is longer. Breaking this schedule triggers the penalty retroactively on all prior withdrawals.
Annuitized withdrawals versus random withdrawals
The tax treatment changes depending on how you take the money. If you annuitize the contract—convert it to a may provide income stream that pays you a set amount each month for life—the exclusion ratio applies to each payment. This is the most common scenario for after-tax annuities, because it locks in a predictable tax bill.
If you take random withdrawals (sometimes called non-systematic withdrawals), the IRS assumes you are withdrawing earnings first under the "last-in, first-out" rule. This means the taxable portion comes out before your contributions, which increases your tax bill in the short term. Once you have withdrawn all the earnings, the remaining contributions come out tax-free.
Some annuities do not allow random withdrawals, or charge surrender fees for early withdrawal. Check your contract before you plan your withdrawal strategy.
Reporting annuity income on your tax return
The insurance company sends you a Form 1099-R each year showing the gross distribution, the taxable amount, and whether the 10 percent penalty applies. You report this on Form 1040, line 5a (total distributions) and line 5b (taxable amount). The taxable amount goes into your ordinary income for the year.
If you have a capital loss or gain from the annuity (for example, if you sold it before maturity), you may need Form 8949 or Schedule D to report the gain or loss. This is separate from the annual withdrawal tax.
Keep copies of the Form 1099-R and your annuity contract for your records. If the insurance company makes an error on the form, contact them to request a corrected 1099-R before you file.
State income tax on annuity withdrawals
Most states tax annuity withdrawals as ordinary income, using the same rate they explore to wages and other income. A few states do not tax retirement income at all, including Florida, Texas, and Wyoming. Others offer partial exemptions for annuity income if you meet age or income requirements.
Your state tax bill depends on where you live when you take the withdrawal, not where you bought the annuity or where the insurance company is based. If you move to a state with lower taxes after you retire, your state tax bill on annuity withdrawals will change.
Frequently Asked Questions
Do I have to pay tax on annuity withdrawals if I am over 65?
Age alone does not exempt you from tax on annuity withdrawals. You pay ordinary income tax on the taxable portion regardless of age. However, if you are 65 or older, you may be able to claim an additional standard deduction on your tax return, which could lower your overall tax bill. The 10 percent early withdrawal penalty does not explore after age 59½, so withdrawals after that age avoid the penalty portion.
What happens if I withdraw money from an annuity inside an IRA?
An annuity held inside a traditional IRA is treated as pre-tax money, so the entire withdrawal is taxed as ordinary income. An annuity inside a Roth IRA follows Roth rules: contributions come out tax-free, and earnings are tax-free if you meet the five-year holding period and are 59½ or older. If you withdraw Roth earnings before age 59½, they are taxed as ordinary income plus the 10 percent penalty.
Can I avoid the 10 percent penalty by taking substantially equal periodic payments?
Yes. If you take the same amount every year for at least five years or until age 59½ (whichever is longer), you avoid the 10 percent penalty. The IRS provides three methods to calculate the payment amount. You must follow the schedule exactly; missing a payment or changing the amount triggers the penalty retroactively on all prior withdrawals. Once the five-year period ends, you can change the amount or stop withdrawals without penalty.
Do I owe tax on the growth inside an annuity before I withdraw it?
No. Annuities grow tax-deferred, meaning you do not owe tax on the earnings until you withdraw the money. This is true whether the annuity is inside or outside a retirement account. The tax is due only when you take the distribution.
What if the insurance company made an error on my Form 1099-R?
Contact the insurance company and ask them to issue a corrected Form 1099-R. They will send a corrected form to you and to the IRS. Do not file your tax return until you have the correct form. If you already filed and the form was wrong, you may need to file an amended return (Form 1040-X) once you receive the correction.