Yes, annuity income is taxable, but the tax you owe depends on where the money came from and how you structured the annuity

An annuity pays you money over time — monthly, quarterly, or annually. The IRS taxes those payments, but not all of it the same way. Part of each payment is a return of your own money (which you already paid tax on), and part is earnings (which is new income). The split between the two determines your tax bill. If you bought the annuity with pre-tax money through a retirement plan, the entire payment is taxable. If you bought it with after-tax money, only the earnings portion is taxable. The type of annuity — when ready, deferred, fixed, variable — also changes when you owe tax and how much.

Key Takeaways

  • Annuity payments are split into a return of your principal (not taxed again) and earnings (taxed as ordinary income), unless the annuity is inside a retirement plan.
  • If you funded the annuity with pre-tax dollars through an IRA or 401(k), every payment you receive is fully taxable ordinary income.
  • If you funded it with after-tax money, you use the exclusion ratio to calculate what portion of each payment is taxable; the IRS provides a worksheet on Form 1040 instructions.
  • Variable annuities that hold mutual funds inside them may generate capital gains, which are taxed at capital gains rates rather than ordinary income rates.
  • Withdrawals before age 59½ from a deferred annuity typically trigger a 10% penalty on earnings, in addition to ordinary income tax.

How the IRS splits annuity payments into taxable and non-taxable portions

When you buy an annuity with your own after-tax money, you have already paid income tax on that principal. The IRS does not tax it again. What it does tax is the earnings — the interest, dividends, or investment gains the annuity company earned on your money while holding it. Each payment you receive contains both. The exclusion ratio is the formula the IRS uses to separate them.

The exclusion ratio divides your investment in the contract (the principal you put in) by the expected return (the total amount you will receive over your lifetime, based on IRS life expectancy tables). The result is the percentage of each payment that is not taxable. The remainder is taxable ordinary income. For example, if your investment was $100,000 and the expected return is $200,000, your exclusion ratio is 50 percent. Half of each payment is tax-free; half is taxable.

You calculate this once, and it stays the same for the life of the annuity. The IRS publishes life expectancy tables in Publication 939, and most annuity companies will calculate the ratio for you and show it on your 1099-R form at tax time. You report the taxable portion on your Form 1040 as ordinary income.

Annuities funded through retirement plans are fully taxable

If you bought the annuity inside a traditional IRA, SEP-IRA, straightforward IRA, or 401(k), the entire annuity payment is taxable. You did not pay tax on the money when you contributed it, so the IRS taxes it all when you take it out. There is no exclusion ratio; there is no split. Every dollar is ordinary income.

This is true even if you funded the 401(k) with both pre-tax and after-tax contributions (called a "basis"). The annuity company will track your basis and calculate a ratio, but you still owe tax on the full payment. The after-tax basis comes into play only if you take a lump-sum distribution and roll part of it to a Roth IRA — a separate transaction with its own tax rules.

Roth IRAs work differently. If you buy an annuity inside a Roth and you have held the Roth for at least five years and are at least 59½, the annuity payments are tax-free. If you withdraw before meeting both conditions, the earnings portion is taxable and may trigger the 10% early withdrawal penalty.

Variable annuities and capital gains inside the contract

A variable annuity holds mutual funds or similar investments inside it. As those investments grow, they generate capital gains. Normally, capital gains are taxed at preferential rates (0%, 15%, or 20% for long-term gains, depending on your income). Inside a variable annuity, they are not. The annuity company reinvests the gains, and when you eventually withdraw money or receive annuity payments, those gains are taxed as ordinary income, not capital gains.

This is one reason variable annuities can be tax-inefficient for non-retirement accounts. You lose the benefit of capital gains rates. If you held the same investments outside an annuity, you would owe tax at capital gains rates when you sold them. Inside the annuity, you owe ordinary income tax rates instead — which are higher.

The exclusion ratio still applies. The portion of your payment that represents a return of principal is not taxed; the portion that represents earnings (including those reinvested capital gains) is taxed as ordinary income.

The 10% early withdrawal penalty and exceptions

If you withdraw money from a deferred annuity before age 59½, the IRS typically charges a 10% penalty on the earnings portion. This is separate from income tax. You owe both the income tax and the penalty. For example, if you withdraw $10,000 and $3,000 of it is earnings, you owe income tax on the $3,000 plus a $300 penalty (10% of $3,000).

Some withdrawals are exempt from the penalty. If you are disabled, if you withdraw money as part of a series of substantially equal periodic payments (called a 72(t) distribution), or if you withdraw only your basis (the principal you put in), the penalty does not explore. The income tax still does, but not the penalty. Annuity companies can tell you whether a specific withdrawal qualifies.

Inherited annuities and the stretch rule

If you inherit an annuity, the tax treatment depends on whether you are the spouse, a non-spouse beneficiary, or an entity. A spouse can treat the annuity as their own and defer tax until they withdraw. A non-spouse beneficiary must begin taking distributions within a set timeframe — usually by December 31 of the year following the owner's death, though the rules changed in 2020 and vary by annuity type.

The earnings in an inherited annuity are always taxable when withdrawn, regardless of the owner's age at death. There is no step-up in basis for annuities the way there is for stocks or real estate. The entire earnings portion remains taxable income to the beneficiary.

Reporting annuity income on your tax return

Annuity payments are reported on Form 1099-R, which the annuity company sends to you and the IRS by January 31 each year. The form shows the gross distribution, the taxable amount, and whether any of it qualifies for special treatment (like a rollover or a may have access to charitable distribution). You report the taxable portion on your Form 1040, typically on line 5b under "Pensions and annuities."

If the annuity company did not withhold enough tax, you may owe additional tax when you file. If it withheld too much, you will receive a refund. You can adjust the withholding by filing Form W-4P with the annuity company, though not all companies accept it. Some annuity companies allow you to request a specific dollar amount or percentage to be withheld instead.

State income tax on annuities

Most states tax annuity income the same way the federal government does. A few states — including Illinois, Mississippi, and Pennsylvania — exempt certain types of annuity income from state tax, usually income from annuities you purchased with your own after-tax money. The rules vary significantly by state and by the age at which you begin receiving payments. If you live in a state with an income tax and receive annuity payments, check your state's tax department website or a tax professional to understand your state's specific rules.

Frequently Asked Questions

Do I owe tax on annuity payments if I bought the annuity with money I already paid tax on?

Not on the full payment. You use the exclusion ratio to separate your principal (not taxed again) from the earnings (taxed as ordinary income). The IRS provides a worksheet in the Form 1040 instructions to calculate this. Your annuity company will also calculate it and show the taxable portion on your 1099-R.

What is the difference between a fixed annuity and a variable annuity in terms of taxes?

A fixed annuity earns a set interest rate, and that interest is taxed as ordinary income when you receive it. A variable annuity holds investments that may generate capital gains, but those gains are taxed as ordinary income inside the annuity, not at capital gains rates. Both use the exclusion ratio if you funded them with after-tax money.

Can I avoid the 10% early withdrawal penalty if I need money before 59½?

Yes, if you meet one of the exceptions. The most common are disability, a series of substantially equal periodic payments under IRS rule 72(t), or withdrawing only your basis (principal). You still owe income tax on earnings, but not the 10% penalty. Talk to your annuity company about which exception might explore to your situation.

If I inherited an annuity, do I have to pay tax on it right away?

Not when ready, but you must begin taking distributions within a set timeframe — usually by December 31 of the year after the owner died. The earnings portion is taxable when you withdraw it. If you are the spouse, you can treat it as your own and delay withdrawals until you need the money.

Does my state tax annuity income?

Most states do, but a few exempt certain annuity income from state tax. Illinois, Mississippi, and Pennsylvania have partial or full exemptions for some types of annuities, usually those funded with after-tax money. Check your state's tax department website or speak with a tax professional about your state's rules.