How are annuities taxed? An annuity grows tax-deferred, and tax is generally owed only when money comes out, taxed as ordinary income rather than at long-term capital gains rates. How much of each dollar is taxable depends on whether the annuity is qualified (funded with pre-tax money) or non-qualified (funded with after-tax money), and on whether you take a lump sum, partial withdrawals, or a stream of annuitized payments.
Annuity earnings are taxed as ordinary income when withdrawn, not as capital gains. A qualified annuity funded with pre-tax dollars is generally fully taxable; a non-qualified annuity taxes only the earnings, and after-tax principal returns tax-free. Withdrawals before age 59½ can add a 10% federal penalty on the taxable portion (Source: IRS Publication 575, 2025; IRS Tax Topic 410).
How are annuities taxed at the core: tax-deferred until withdrawal
At the core, an annuity is taxed on a deferral basis: the growth inside the contract is not taxed each year, and tax is generally triggered only when money is withdrawn or paid out. The earnings portion is then treated as ordinary income taxed at your bracket for that year, rather than at long-term capital gains rates (Source: IRS Publication 575, 2025; IRS Tax Topic 410).
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An annuity’s growth is not taxed each year while it stays inside the contract. Tax is generally triggered only when money is withdrawn or paid out, and the earnings portion is treated as ordinary income rather than at long-term capital gains rates (Source: IRS Publication 575, 2025). This deferral is a defining tax feature of the product.
Because gains are ordinary income, the rate applied depends on your tax bracket in the year of the distribution, not on how long the contract was held. A narrow exception exists for certain lump-sum distributions involving employer securities and net unrealized appreciation (Source: IRS Publication 575, 2025), a topic covered in Q3’s separate research note on net unrealized appreciation.
The next question that usually follows is how much of a withdrawal is taxable, and that turns on how the annuity was funded.
Qualified vs. non-qualified annuities: pre-tax vs. after-tax funding
The split turns on funding. A qualified annuity holds pre-tax dollars inside a retirement plan, so withdrawals are generally fully taxable as ordinary income. A non-qualified annuity holds after-tax dollars, so only the earnings are taxable and the original principal is returned tax-free. This funding difference then drives which IRS method applies and whether RMDs come into play (Source: IRS Publication 575, 2025; IRS Tax Topic 410).
A qualified annuity is funded with pre-tax dollars inside a retirement plan such as a 401(k), 403(b), or traditional IRA, so withdrawals are generally fully taxable as ordinary income when no after-tax contributions were made. A non-qualified annuity is funded with after-tax dollars, so only the earnings are taxable and the original principal is returned tax-free (Source: IRS Publication 575, 2025; IRS Tax Topic 410).
This distinction drives nearly every other tax result below, including which IRS calculation method applies and whether required minimum distributions come into play. The table summarizes the difference.
| Feature | Qualified annuity | Non-qualified annuity |
|---|---|---|
| Funding | Pre-tax (401(k), 403(b), traditional IRA) | After-tax dollars |
| Taxable portion of withdrawal | Generally the entire amount | Earnings only; principal is tax-free |
| Tax character | Ordinary income | Ordinary income (earnings) |
| IRS payout method | Simplified Method (starting dates after Nov. 18, 1996) | General Rule (actuarial tables) |
| Required minimum distributions | Yes, generally from age 73 | Generally no lifetime RMD |
| 3.8% Net Investment Income Tax | Distributions are not net investment income | Earnings can be net investment income |
Source for table: IRS Publication 575 (2025); IRS Tax Topic 410; IRS Net Investment Income Tax guidance; SECURE 2.0 Act Section 107.
How non-qualified withdrawals are taxed: the LIFO earnings-first rule
Partial withdrawals from a non-qualified annuity follow an earnings-first rule. For contracts entered into after August 13, 1982, the taxable gain is treated as coming out before any tax-free return of after-tax principal. This last-in, first-out ordering means early withdrawals from a profitable contract are generally fully taxable until the entire gain has been distributed (Source: IRC Section 72(e); IRS Publication 575, 2025).
When you take a partial withdrawal from a non-qualified annuity (an amount not received as a scheduled annuity payment), the IRS treats earnings as coming out first. Under the income-first rule, the taxable gain is withdrawn and taxed before any tax-free return of your after-tax principal, for contracts entered into after August 13, 1982 (Source: IRC Section 72(e); IRS Publication 575, 2025).
This last-in-first-out ordering means early withdrawals from a profitable non-qualified annuity are generally fully taxable until the entire gain has been distributed. Only after the earnings are exhausted does the remaining principal come out tax-free.
Your after-tax contributions are called your cost, or investment in the contract. That figure is the amount you can eventually recover free of tax, and it anchors the exclusion ratio math below.
The exclusion ratio for annuitized income payments
When a non-qualified annuity is annuitized into periodic payments, each payment splits into a tax-free return of principal and a taxable earnings portion. The tax-free share is set by the exclusion ratio: your investment in the contract divided by the expected total return under the contract. That fixed percentage applies to each payment until your full cost is recovered (Source: IRC Section 72(b); IRS Publication 575, 2025).
When a non-qualified annuity is annuitized into a stream of periodic payments, each payment is split into a tax-free return of principal and a taxable earnings portion. The tax-free share is set by the exclusion ratio: your investment in the contract divided by the expected total return under the contract (Source: IRC Section 72(b); IRS Publication 575, 2025).
Exclusion ratio example: If your investment in the contract is $100,000 and the expected return is $200,000, the ratio is 50%. On a $1,000 monthly payment, roughly $500 is a tax-free return of principal and $500 is taxable earnings, until your full $100,000 cost is recovered (Source: IRC Section 72(b); IRS Publication 575, 2025).
The statute is explicit: gross income excludes the part of each payment that bears the same ratio to the payment as the investment in the contract bears to the expected return (Source: IRC Section 72(b)). The expected return for a life annuity is estimated using IRS actuarial tables found in Publication 939 (Source: IRS Publication 939, Rev. Dec. 2025).
What happens after your cost is fully recovered
The tax-free recovery of cost is capped at your total investment in the contract, for annuities with starting dates after 1986. Once you have recovered your entire cost tax-free, every later payment becomes fully taxable as ordinary income (Source: IRS Publication 575, 2025). Payments received in years after the full cost has been recovered are therefore taxable in full.
If instead the annuitant dies before recovering the full cost, the unrecovered investment may be claimed as an itemized deduction on the decedent’s final income tax return (Source: IRS Publication 575, 2025).
Simplified Method vs. General Rule: which IRS calculation applies
Two IRS methods set the tax-free portion of annuitized payments, and which applies depends on the annuity type. The Simplified Method is generally mandatory for annuities paid under a qualified plan with a starting date after November 18, 1996, and cannot be used for non-qualified annuities. Non-qualified annuities must instead use the General Rule with actuarial tables (Source: IRS Tax Topic 410; IRS Publication 575, 2025).
Two IRS methods determine the tax-free portion of annuitized payments, and the right one depends on whether the annuity is qualified. The Simplified Method is generally mandatory for annuities paid under a qualified plan with a starting date after November 18, 1996, and it cannot be used for non-qualified annuities. Non-qualified annuities must use the General Rule with actuarial tables (Source: IRS Tax Topic 410; IRS Publication 575, 2025; IRS Publication 939, Rev. Dec. 2025).
Under the Simplified Method, the tax-free amount per payment equals your total cost divided by a fixed number of anticipated monthly payments based on your age at the annuity starting date. For a single life, the payment count for age 55 and under is 360, and the divisor decreases as starting age rises because life expectancy is shorter (Source: IRS Publication 575, 2025). The tax-free amount is then fixed for the life of the annuity.
The exact divisors for older age bands and for joint-life annuities are listed in the Simplified Method Worksheet in IRS Publication 575; the specific figures should be read directly from that worksheet before filing (Source: IRS Publication 575, 2025).
Lump sum vs. annuitized payments: how the tax timing differs
The choice between a lump sum and annuitized payments changes when tax is due. A lump sum from a non-qualified annuity applies the earnings-first rule, so the full gain is taxable in the year received. Annuitizing spreads the taxable earnings across many years through the exclusion ratio, so a smaller taxable slice is reported each year (Source: IRS Publication 575, 2025; IRC Sections 72(b) and 72(e)).
Taking a lump sum and taking annuitized payments produce different tax timing. A lump sum from a non-qualified annuity applies the LIFO earnings-first rule, so the entire gain is taxable in the year received, potentially pushing income into higher brackets. Annuitizing spreads the taxable earnings across many years through the exclusion ratio, so a smaller taxable slice is reported each year (Source: IRS Publication 575, 2025; IRC Sections 72(b) and 72(e)).
Because taxable annuity income is ordinary income, a large single-year distribution can interact with other retirement thresholds, including Medicare IRMAA surcharges and the taxation of Social Security. The timing of income and its effect on those thresholds is one factor to weigh when comparing annuitization with lump-sum access (Source: IRS Publication 575, 2025).
The 10% early withdrawal penalty before age 59½
A 10% additional federal tax generally applies to the taxable portion of a distribution taken before age 59½. For qualified plans and IRAs the authority is IRC Section 72(t); for non-qualified annuity contracts it is IRC Section 72(q). The penalty does not apply at or after age 59½, and only to amounts includible in income (Source: IRC Sections 72(t) and 72(q); IRS Tax Topic 558).
Because the penalty attaches only to the amount includible in gross income, a tax-free return of cost from a non-qualified annuity is not subject to the additional tax (Source: IRC Sections 72(t) and 72(q); IRS Tax Topic 410). Several statutory exceptions can remove the penalty entirely.
Exceptions to the 10% penalty
Federal law lists specific exceptions that remove the 10% additional tax even before age 59½. These are defined statutory categories, not discretionary choices, and they include events such as death, disability, substantially equal periodic payments, certain medical costs, and several situations added by the SECURE 2.0 Act. The list below summarizes the main exceptions (Source: IRS Tax Topic 558; IRC Section 72(t)).
- Death of the account owner or total and permanent disability.
- Substantially equal periodic payments (SEPP) under Section 72(t), sometimes called a 72(t) schedule.
- Separation from service at age 55 or later for qualified plans; age 50 or 25 years of service for qualified public safety employees.
- Unreimbursed medical expenses above 7.5% of adjusted gross income, and IRS levies.
- Qualified reservist distributions, up to $5,000 for a qualified birth or adoption, and terminal illness.
- SECURE 2.0 additions effective after Dec. 31, 2023: domestic abuse victim, federally declared disaster, and emergency personal expense distributions.
The penalty is generally reported on IRS Form 5329, unless Form 1099-R shows distribution code 1 and the tax is reported directly on Schedule 2 (Source: IRS Tax Topic 558).
1035 exchanges: swapping one annuity for another tax-free
Under IRC Section 1035, no gain or loss is recognized when an annuity contract is exchanged for another annuity contract, or when a life insurance or endowment contract is exchanged for an annuity. The statute does not permit an annuity to be exchanged tax-free into a life insurance policy. This defers, rather than eliminates, tax on the built-in gain (Source: 26 U.S.C. Section 1035; IRS Publication 575, 2025).
In a properly structured 1035 exchange, the basis rules of Section 1031 apply, so the investment in the contract generally carries over to the new annuity and the deferral continues rather than resetting (Source: 26 U.S.C. Section 1035(d); 26 U.S.C. Section 1031(d)). Taking the money in cash and buying a new annuity separately would not qualify as a Section 1035 exchange and could be fully taxable to the extent of the gain (Source: 26 U.S.C. Section 1035; IRS Publication 575, 2025).
How inherited annuities are taxed
A beneficiary who inherits an annuity generally owes ordinary income tax on the earnings portion as it is received, while the after-tax principal in a non-qualified annuity is still returned tax-free. Annuity earnings are treated as income in respect of a decedent, so they do not receive a step-up in basis and the built-in gain remains taxable to the beneficiary (Source: IRS Publication 575, 2025; IRC Section 691).
Distribution timing after death depends on the beneficiary type. For account-based inherited retirement interests, most designated beneficiaries who are not eligible designated beneficiaries generally must empty the account within 10 years, while eligible designated beneficiaries (a surviving spouse, a minor child of the owner, a disabled or chronically ill person, or a person not more than 10 years younger than the owner) may use longer, life-expectancy-based options (Source: IRC Section 401(a)(9)(H) and (E); IRS Publication 590-B, 2025). A surviving spouse often has additional continuation choices (Source: IRS Publication 590-B, 2025).
State taxation of annuities
Federal rules are only part of the picture, because states tax annuity income under their own laws. Whether you owe state income tax on annuity distributions depends on your state of residence: some states levy no income tax, some exempt part of retirement income, and some impose a premium tax when an annuity is purchased. Confirm current rules with your state’s department of revenue (Source: IRS Publication 575, 2025 for federal treatment; state treatment varies).
| State category | General treatment of annuity income |
|---|---|
| States with no state income tax | No state income tax on annuity distributions. |
| States with retirement-income exemptions | May exempt qualifying retirement income, which can include certain annuity income, subject to state-specific conditions. |
| States with an annuity premium tax | May charge a premium tax at purchase or annuitization; the rate and timing depend on the state. |
| Most other states | Generally tax annuity earnings as part of ordinary state taxable income. |
State categories, exemptions, and any premium tax vary and change; verify against your state department of revenue and current statutes before relying on them. Federal treatment above is per IRS Publication 575 (2025).
The 3.8% Net Investment Income Tax on non-qualified annuities
Earnings from a non-qualified annuity can be subject to an additional 3.8% Net Investment Income Tax on top of ordinary income tax, because those distributions count as net investment income. Distributions from qualified plans and IRAs are not net investment income and are excluded from this tax. The surtax applies only when modified adjusted gross income exceeds set thresholds (Source: IRC Section 1411; IRS Net Investment Income Tax guidance).
The 3.8% surtax applies when modified adjusted gross income exceeds $200,000 for single or head of household filers, $250,000 for married filing jointly, and $125,000 for married filing separately. These thresholds are not indexed for inflation and have been fixed since enactment (Source: IRS Net Investment Income Tax guidance; IRC Section 1411). Q3’s separate note on the Net Investment Income Tax for 2026 covers the mechanics in more depth.
RMDs, Roth annuities, and 2026 figures
Qualified annuities held inside retirement accounts are generally subject to required minimum distributions beginning at age 73 under the SECURE 2.0 Act. A Roth IRA annuity can produce tax-free qualified distributions once the owner meets the age and holding requirements. For 2026 the elective deferral limit is $24,500 and the IRA limit is $7,500 (Source: SECURE 2.0 Act Section 107; IRS Notice 2025-67).
The age-73 RMD rule under SECURE 2.0 Act Section 107 applies to individuals born after 1950, and the first RMD may be delayed until April 1 of the year after you reach 73 (Source: SECURE 2.0 Act Section 107; IRS Publication 590-B, 2025). Individual retirement annuities follow special RMD rules under the Treasury regulations. Details are in Q3’s 2026 required minimum distributions note.
A Roth IRA annuity can produce qualified distributions that are entirely tax-free once the account owner is at least 59½ and the Roth 5-year holding requirement is met (Source: IRC Section 408A(d); IRS Publication 590-B, 2025). Q3 describes the mechanics of converting pre-tax retirement money to Roth on its Roth conversion service page.
For 2026 the IRS set the 401(k), 403(b), and governmental 457(b) elective deferral limit at $24,500 and the IRA contribution limit at $7,500 (or $8,600 for those age 50 or older, reflecting a $1,100 IRA catch-up), with a standard age-50 catch-up of $8,000 in the 401(k)-type plans and a SECURE 2.0 higher catch-up of $11,250 for ages 60 to 63 (Source: IRS Notice 2025-67). See Q3’s 2026 retirement contribution limits for the full schedule.
How annuity distributions are reported: Form 1099-R
Annuity payers report distributions on IRS Form 1099-R, which reports the gross distribution, the taxable amount when known, and a distribution code that can flag an early distribution. Taxpayers use this form to report annuity income and, where relevant, to calculate the tax-free portion using the Simplified Method or General Rule (Source: IRS Instructions for Forms 1099-R and 5498, 2025; IRS Publication 575, 2025).
Governing references for computing the taxable amount include IRS Publication 575 and IRS Tax Topic 410 (Source: IRS Publication 575, 2025; IRS Tax Topic 410).
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Q3 Advisors is a registered investment adviser focused on retirement tax planning. This article is educational and is not advice; for guidance on your own circumstances, consult a qualified tax or financial professional.
Frequently asked questions
How much tax do you pay on annuity withdrawals?
You generally pay ordinary income tax on the taxable portion of an annuity withdrawal at your marginal rate for that year, not capital gains rates. A qualified annuity is usually fully taxable; a non-qualified annuity taxes only the earnings, which come out first under the LIFO rule. Withdrawals before age 59½ can add a 10% federal penalty on the taxable amount (Source: IRS Publication 575, 2025; IRC Section 72(e)).
Are annuity death benefits taxable?
Annuity death benefits are generally taxable to the beneficiary on the earnings portion, taxed as ordinary income as it is received. The after-tax principal in a non-qualified annuity is returned tax-free, but the earnings are income in respect of a decedent and receive no step-up in basis. A qualified annuity’s death benefit is usually fully taxable to the beneficiary (Source: IRS Publication 575, 2025; IRC Section 691).
Do I pay state taxes on annuity income?
Whether you pay state tax on annuity income depends on your state of residence. States with no income tax do not tax annuity distributions, and some states exempt qualifying retirement income under state-specific conditions. Certain states also apply an annuity premium tax at purchase. Confirm current rules with your state department of revenue (Source: state law varies; IRS Publication 575, 2025 for federal treatment).
How are annuity taxes deferred and when do they come due?
Tax on annuity earnings is generally deferred while money stays inside the contract, not eliminated, and it comes due when money is withdrawn or paid out. A Section 1035 exchange defers tax when one annuity is exchanged for another, and a Roth IRA annuity can produce tax-free qualified distributions once requirements are met. These are factors to weigh, not recommendations (Source: 26 U.S.C. Section 1035; IRC Section 408A(d)).
Are annuities taxed as ordinary income or capital gains?
Annuity earnings are taxed as ordinary income, not at long-term capital gains rates, even for variable annuities invested in the market. This applies to withdrawals, annuitized payments, and inherited earnings alike. A narrow exception involves certain lump-sum distributions with employer securities and net unrealized appreciation (Source: IRS Publication 575, 2025).
How is an inherited annuity taxed?
An inherited annuity is taxed to the beneficiary as ordinary income on the earnings portion; after-tax principal in a non-qualified annuity remains tax-free, and the earnings receive no step-up in basis. Most designated beneficiaries who are not eligible designated beneficiaries generally must withdraw the full balance within 10 years, while eligible designated beneficiaries may use longer, life-expectancy options (Source: IRS Publication 575, 2025; IRS Publication 590-B, 2025; IRC Section 401(a)(9)(H)).
What is the exclusion ratio on an annuity?
The exclusion ratio is the fraction of each annuitized payment that is a tax-free return of principal. It equals your investment in the contract divided by the expected total return under the contract. If your cost is $100,000 and expected return is $200,000, the ratio is 50%, so half of each payment is tax-free until your full cost is recovered (Source: IRC Section 72(b); IRS Publication 575, 2025).
Do you pay taxes on an annuity every year?
You generally do not pay annual tax while money stays inside a deferred annuity, because growth is tax-deferred. Tax is owed in years you take withdrawals or receive annuitized payments. Once you begin annuity payments, the taxable earnings portion is reported each year, and payments become fully taxable after your entire cost has been recovered tax-free (Source: IRS Publication 575, 2025).
Sources
IRS Publication 575 (2025), Pension and Annuity Income: https://www.irs.gov/publications/p575
IRS Publication 939 (Rev. Dec. 2025), General Rule for Pensions and Annuities: https://www.irs.gov/publications/p939
IRS Publication 590-B (2025), Distributions from IRAs: https://www.irs.gov/publications/p590b
IRS Tax Topic 410, Pensions and Annuities: https://www.irs.gov/taxtopics/tc410
IRS Tax Topic 558, Additional Tax on Early Distributions: https://www.irs.gov/taxtopics/tc558
IRS Net Investment Income Tax: https://www.irs.gov/individuals/net-investment-income-tax
IRS Instructions for Forms 1099-R and 5498 (2025): https://www.irs.gov/forms-pubs/about-form-1099-r
IRS Notice 2025-67, 2026 amounts relating to retirement plans and IRAs: https://www.irs.gov/pub/irs-drop/n-25-67.pdf
IRS newsroom, 401(k) limit increases to $24,500 for 2026, IRA limit increases to $7,500: https://www.irs.gov/newsroom/401k-limit-increases-to-24500-for-2026-ira-limit-increases-to-7500
26 U.S.C. Section 72 (Cornell LII): https://www.law.cornell.edu/uscode/text/26/72
26 U.S.C. Section 408A, Roth IRAs (Cornell LII): https://www.law.cornell.edu/uscode/text/26/408A
26 U.S.C. Section 401(a)(9) (Cornell LII): https://www.law.cornell.edu/uscode/text/26/401
26 U.S.C. Section 691, Income in respect of a decedent (Cornell LII): https://www.law.cornell.edu/uscode/text/26/691
26 U.S.C. Section 1031, Basis rules (Cornell LII): https://www.law.cornell.edu/uscode/text/26/1031
26 U.S.C. Section 1035 (Cornell LII): https://www.law.cornell.edu/uscode/text/26/1035
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Disclaimer
This article is provided by Q3 Advisors for educational and informational purposes only. It is not tax, legal, investment, or financial advice, and it is not a recommendation to buy, sell, or hold any annuity or other product. Tax rules are complex and depend on individual circumstances, and figures and thresholds cited reflect information available as of July 2026 and may change. Consult a qualified tax or financial professional about your own situation. Q3 Advisors is a registered investment adviser; additional information is available in its Form ADV.
