Annuity income is taxable, but the tax you owe depends on where the money came from and when you withdraw it

Not all annuity income is taxed the same way. The tax bill on your annuity withdrawals depends on three things: whether you funded the annuity with pre-tax or after-tax dollars, whether the annuity is still in its accumulation phase (growing) or payout phase (paying you), and how long you've owned it. A withdrawal from a nonqualified annuity you bought with your own money is taxed differently from a withdrawal from an annuity funded through a 401(k). Understanding which rule applies to your annuity means knowing what portion of each payment is taxable income and what portion is straightforward your own money coming back to you.

Key Takeaways

  • Earnings inside an annuity grow tax-deferred, but when you withdraw them, they are taxed as ordinary income at your full tax rate, not as capital gains.
  • In a nonqualified annuity (one you bought with after-tax money), withdrawals use the "last-in, first-out" rule, so you pay tax on earnings first, then get your contributions back tax-free.
  • Annuities funded through retirement plans like 401(k)s or IRAs are fully taxable when withdrawn because the contributions were pre-tax.
  • If you withdraw from an annuity before age 59½, you may owe a 10 percent early withdrawal penalty on top of ordinary income tax, though some annuities have exceptions.
  • Annuity payouts that come as a stream of regular payments (rather than a lump sum) may include a tax-free return of your principal mixed into each payment.

How tax-deferred growth works inside an annuity

An annuity is a contract with an insurance company. You give them money, and in return they promise to pay you later. The key tax feature is that money inside the annuity grows without triggering a tax bill each year. If you own a mutual fund, you pay tax on dividends and capital gains every year. If you own an annuity, those same earnings sit untaxed until you take the money out. This is called tax-deferred growth.

This deferral is valuable because your money compounds faster when taxes don't eat into it each year. But the deferral is not permanent. When you withdraw money from the annuity, the IRS wants its share of the earnings that accumulated inside. The tax bill arrives when you take the money out, not while it sits there growing.

Nonqualified annuities: the taxation of after-tax contributions

A nonqualified annuity is one you bought with money that was already taxed — money from your paycheck after income tax was withheld, or money you earned and paid tax on. You funded it with after-tax dollars, so your contributions are not deductible.

When you withdraw from a nonqualified annuity, the IRS uses the last-in, first-out (LIFO) rule. This means earnings come out first and are taxed as ordinary income. Your original contributions come out last and are returned to you tax-free, because you already paid tax on that money when you earned it. If you put $100,000 into a nonqualified annuity and it grew to $150,000, the first $50,000 you withdraw is taxable earnings. The next $100,000 is your contribution, returned tax-free.

This rule applies whether you take a lump sum or receive regular payments. The difference is that with regular payments, the insurance company calculates what portion of each payment is earnings and what portion is your contribution, and reports both to you and the IRS on Form 1099-R.

may have access to annuities: the taxation of retirement plan money

A may have access to annuity is one funded with pre-tax money from a retirement plan — a 401(k), 403(b), traditional IRA, or similar account. Because your contributions were deductible when you made them, the IRS never taxed that money. Now it wants to tax it when it comes out.

With a may have access to annuity, all withdrawals are taxed as ordinary income. There is no distinction between your contributions and earnings, because both were pre-tax. If you withdraw $10,000 from a may have access to annuity, the full $10,000 is ordinary income and subject to tax at your marginal rate. This is true even if you funded the annuity with contributions and it earned very little.

may have access to annuities are also subject to required minimum distributions (RMDs) starting at age 73 (as of 2023, under current law). You must withdraw a calculated amount each year, and that amount is fully taxable. If you do not take the RMD, the IRS imposes a penalty equal to 25 percent of the shortfall (reduced to 10 percent if corrected within two years).

The ordinary income tax rate on annuity earnings

Annuity earnings are taxed as ordinary income, not as capital gains. This is a crucial difference. If you sold a stock you held for more than a year, the profit would be taxed as a long-term capital gain, which is usually taxed at 0, 15, or 20 percent depending on your income. Annuity earnings are taxed at your ordinary income tax rate, which can be as high as 37 percent at the federal level, plus state income tax if your state has one.

This is one reason annuities are often recommended for people in lower tax brackets during retirement, or for people who expect to be in a lower bracket when they withdraw than they are now. If you are in the 24 percent bracket while working and expect to be in the 12 percent bracket in retirement, the tax deferral saves you 12 cents on every dollar of earnings. If you stay in the same bracket, the deferral saves you nothing — it just delays the bill.

Early withdrawal penalties and exceptions

If you withdraw money from an annuity before age 59½, you may owe a 10 percent early withdrawal penalty on top of ordinary income tax. This penalty applies to the taxable portion of the withdrawal — the earnings in a nonqualified annuity, or the entire withdrawal from a may have access to annuity.

Some annuities have built-in exceptions. Many allow you to withdraw a small percentage of the account value each year (often 10 percent) without penalty. Some allow penalty-free withdrawal if you become disabled or begin taking substantially equal periodic payments (a specific IRS formula). If you annuitize — convert the annuity into a stream of may provide payments for life — the payments themselves are not subject to the early withdrawal penalty, though they are still taxable.

The 10 percent penalty is separate from income tax. If you are in the 24 percent tax bracket and withdraw $10,000 in taxable earnings before age 59½, you owe $2,400 in income tax plus $1,000 in penalty, for a total of $3,400. This is why early withdrawal from an annuity is expensive and should be avoided unless you have no other option.

Annuity payouts and the exclusion ratio

If you choose to receive your annuity as a series of regular payments (annuitization) rather than a lump sum, the insurance company calculates an exclusion ratio. This ratio determines what portion of each payment is a tax-free return of your principal and what portion is taxable earnings.

The exclusion ratio is your total contribution divided by the total expected payout over your life. If you contributed $100,000 and the insurance company calculates that you will receive $200,000 total over your life expectancy, your exclusion ratio is 50 percent. Each payment is half tax-free return of principal and half taxable earnings. Once you have recovered your entire contribution, all remaining payments are fully taxable.

This calculation applies only to nonqualified annuities. With a may have access to annuity, there is no exclusion ratio — all payments are fully taxable, because all of your contributions were pre-tax.

State income tax and annuity withdrawals

Most states that have an income tax will tax annuity withdrawals the same way the federal government does. A few states exempt retirement income, including annuity payouts, from state income tax. Tennessee and New Hampshire, for example, do not tax income from annuities or other retirement sources. If you live in one of these states, your state tax bill on annuity withdrawals is zero, though you still owe federal tax.

Some states offer partial exemptions for annuity income above a certain age or income level. Because state rules vary, it is worth checking your state's tax department website or speaking with a tax professional in your state to understand how your specific annuity withdrawal will be taxed at the state level.

Frequently Asked Questions

Do I have to pay tax on annuity money while it is still growing inside the contract?

No. The entire point of an annuity is tax deferral. You pay no tax on earnings, interest, or gains while the money sits in the annuity. Tax is due only when you withdraw money from the contract.

What is the difference between a nonqualified and may have access to annuity for tax purposes?

A nonqualified annuity is funded with after-tax money, so your contributions come back tax-free and only earnings are taxed. A may have access to annuity is funded with pre-tax retirement plan money, so all withdrawals are fully taxable. With a may have access to annuity, there is no tax-free return of contributions.

Can I avoid the 10 percent early withdrawal penalty by taking small amounts each year?

Not automatically. The 10 percent penalty applies to early withdrawals regardless of size, unless your annuity contract includes a free withdrawal provision or you meet an IRS exception like disability or substantially equal periodic payments. Check your annuity contract for any penalty-free withdrawal rights.

If I annuitize my annuity, do I pay tax on the full payment or just part of it?

Only part of it, if it is a nonqualified annuity. The insurance company calculates an exclusion ratio that determines what portion of each payment is your tax-free principal and what portion is taxable earnings. With a may have access to annuity, the full payment is taxable.

Does the tax treatment of my annuity change if I move it to a different insurance company?

No. A direct transfer from one annuity to another (called a 1035 exchange) does not trigger a tax bill, and the tax treatment of the new annuity is the same as the old one. However, if you withdraw the money and then buy a new annuity, the withdrawal is fully taxable and may be subject to the early withdrawal penalty.