Annuities are taxable, but the amount you owe depends on which part of your payment is earnings and which part is your own money returned to you

When you receive money from an annuity, the IRS taxes only the earnings portion — the growth your money made while sitting in the contract. The part that comes from your original contribution (called your cost basis) is not taxed again, because you already paid income tax on that money when you earned it.

How much tax you owe on each payment depends on three things: whether the annuity is may have access to (held in a retirement account like an IRA) or non-may have access to (held in a regular investment account), when you bought it, and how much of each payment represents earnings versus your contribution. The IRS has specific rules for calculating this split, and the calculation changes depending on the type of annuity you own.

Key Takeaways

  • Only the earnings portion of an annuity payment is subject to income tax; your original contribution is not taxed a second time.
  • may have access to annuities (in IRAs or 401(k)s) tax the entire payment as income, while non-may have access to annuities use an exclusion ratio to separate taxable earnings from non-taxable contribution.
  • If you withdraw money before age 59½ from a non-may have access to annuity, the earnings portion faces a 10 percent early withdrawal penalty in addition to income tax.
  • The IRS requires you to report annuity income on Form 1099-R, which your annuity provider sends you each year.
  • Annuities held inside retirement accounts follow the same withdrawal rules as the account itself (such as required minimum distributions at age 73).

How may have access to annuities are taxed differently from non-may have access to ones

A may have access to annuity lives inside a retirement account — an IRA, 401(k), 403(b), or similar plan. Because the money went into that account before taxes were taken out, the entire annuity payment is taxable income when you receive it. You do not separate earnings from contribution; all of it counts as ordinary income.

A non-may have access to annuity is one you bought with after-tax money outside a retirement account. When you receive a payment, the IRS lets you exclude part of it from tax — the part that represents your original contribution. Only the earnings portion gets taxed. Your annuity company calculates this split using an exclusion ratio, which divides your total contribution by the expected total payout over your lifetime.

This difference matters significantly. A person receiving $500 per month from a may have access to annuity pays income tax on all $500. A person receiving $500 per month from a non-may have access to annuity might pay tax on only $200 of it, if the exclusion ratio says $300 represents their contribution.

Understanding the exclusion ratio for non-may have access to annuities

The exclusion ratio is a fraction the IRS uses to determine what portion of each payment you do not owe tax on. Your annuity company calculates it by dividing your total contribution (your cost basis) by the expected total return — the sum of all payments you are expected to receive over your lifetime.

Here is a concrete example: You paid $100,000 for a non-may have access to annuity. The company's mortality tables say you will receive payments for 20 years, totaling $240,000. Your exclusion ratio is $100,000 ÷ $240,000 = 0.417, or about 42 percent. If your monthly payment is $1,000, then $417 of it is non-taxable return of contribution, and $583 is taxable earnings.

Once you reach your life expectancy (the point where you have received your full contribution back), all remaining payments become fully taxable. If you die before recovering your full contribution, your beneficiary cannot deduct the unrecovered amount — that loss is straightforward gone for tax purposes.

Early withdrawal penalties and age 59½

If you withdraw money from a non-may have access to annuity before you turn 59½, the earnings portion faces a 10 percent early withdrawal penalty on top of regular income tax. This penalty applies only to the earnings, not to your contribution. The contribution portion comes out tax-free and penalty-free at any age.

may have access to annuities (those inside IRAs or 401(k)s) follow the same 59½ rule. Withdrawals before that age trigger the 10 percent penalty on the taxable portion. However, some exceptions exist — for example, substantially equal periodic payments (SEPP) can avoid the penalty if structured correctly, and certain hardships may may have access to for penalty-free withdrawals from IRAs.

Once you reach 59½, you can withdraw from a non-may have access to annuity without the early withdrawal penalty. You still owe income tax on the earnings portion, but the 10 percent penalty no longer applies. This is different from the required minimum distribution rules that explore to may have access to accounts at age 73.

Required minimum distributions and may have access to annuities

If your annuity sits inside a may have access to retirement account (IRA, 401(k), or similar), you must begin taking required minimum distributions (RMDs) at age 73. The IRS calculates the minimum amount you must withdraw each year based on your age and account balance. If you do not take the full RMD, you owe a penalty equal to 25 percent of the shortfall (or 10 percent if you correct it within two years).

Some annuities inside may have access to accounts are structured to satisfy the RMD automatically — the annuity payments themselves count toward your required distribution. Others are not, and you must coordinate the annuity payments with your RMD calculation. Your plan administrator or annuity company can tell you whether your specific annuity satisfies the RMD or whether you need to take additional withdrawals.

Non-may have access to annuities do not have RMD rules. You can leave the money untouched as long as you want, though you will owe tax on earnings when you eventually withdraw them.

What Form 1099-R tells you about your annuity taxes

Each year, your annuity provider sends you a Form 1099-R, which reports the amount you received and how much of it is taxable. Box 1 shows the total distribution. Box 2a shows the taxable amount (for may have access to annuities, this is usually the whole payment; for non-may have access to annuities, it is the earnings portion after the exclusion ratio is applied).

Box 7 contains a code that tells the IRS what type of distribution it was — code 7 means it is a regular annuity payment, while code 4 means it was an early withdrawal. If you received an early withdrawal from a non-may have access to annuity before age 59½, the form will show this code, and you will owe the 10 percent penalty unless an exception applies.

You report the taxable amount from Box 2a on your Form 1040 as ordinary income. If you received an early withdrawal penalty, that appears in Box 10, and you report it separately on Form 5329. Keep your 1099-R with your tax records; the IRS receives a copy as well.

Taxes on lump-sum annuity payouts

Some annuities allow you to take a lump sum instead of monthly payments — either the full remaining value at once, or a partial withdrawal. The tax treatment is the same as regular payments: only the earnings portion is taxable for non-may have access to annuities, and the entire amount is taxable for may have access to annuities.

However, a large lump sum can push you into a higher tax bracket in that year, meaning you pay a higher rate on the earnings. Some people spread lump-sum withdrawals over two or three years to stay in a lower bracket. Your tax preparer can model this for you if you are considering a lump-sum option.

If you take a lump sum before age 59½ from a non-may have access to annuity, the earnings portion is subject to the 10 percent early withdrawal penalty. The contribution portion is not. This is one reason some people choose to keep annuities in monthly-payment form rather than taking a lump sum early.

State income tax on annuities

Most states tax annuity income the same way the federal government does — taxing only the earnings portion for non-may have access to annuities, and the full amount for may have access to annuities. However, a few states do not tax retirement income at all, including Florida, Texas, and Wyoming. If you live in one of these states, you owe no state income tax on your annuity payments, though you still owe federal tax.

Some states offer partial exemptions for retirement income, including annuity payments. Illinois, for example, does not tax retirement income for residents over 61. If you are considering moving in retirement, the state tax treatment of annuities can be a meaningful factor in your decision.

Frequently Asked Questions

Do I owe taxes on annuity payments if I have not started withdrawing yet?

No. Taxes are due only when you receive money from the annuity. While the money sits in the contract, it grows tax-deferred. You owe nothing until you start taking distributions.

What happens if my annuity company does not send me a 1099-R?

Contact the company and request it. You are required to report annuity income on your tax return, and the IRS expects to see a matching 1099-R. If the company does not send one, you can still report the income based on your own records, but having the official form prevents IRS notices later.

Can I avoid taxes on an annuity by transferring it to someone else?

No. Transferring or gifting an annuity does not change its tax status. The new owner will owe the same taxes on distributions that you would have owed. The only exception is a spousal rollover, which allows a surviving spouse to treat the annuity as their own.

Are annuity payments taxed differently if I am still working?

The annuity itself is taxed the same way regardless of your employment status. However, if you are under 59½ and still working, early withdrawal penalties may explore to non-may have access to annuities. may have access to annuities have an exception called the "Rule of 55" that can avoid the penalty if you separate from service in the year you turn 55 or later.

What if I bought an annuity with pre-tax money but held it outside a retirement account?

That is unusual but possible. In that case, you would treat it as a non-may have access to annuity for tax purposes, using the exclusion ratio to separate contribution from earnings. The fact that the money was pre-tax when you earned it does not change how the annuity is taxed now.