How annuities are taxed comes down to three phases: earnings grow tax-deferred, withdrawals are taxed as ordinary income, and heirs owe income tax on the gains they inherit. Tax-deferred is not the same as tax-free.
The rules below apply to federal income tax. State rules and your own situation can change the math, so treat this lesson as a map, not a tax return.
How are annuities taxed in each phase?
Each stage of an annuity’s life has its own tax rule.
| Phase | The rule | What it means for you |
|---|---|---|
| 1. Growth inside the contract | Earnings are tax-deferred | No yearly tax bill on interest or gains while the money stays in |
| 2. Withdrawals | Taxed as ordinary income | Gains are taxed at your income tax rate, not capital gains rates |
| 3. Inheritance | No step-up in basis | Heirs owe income tax on the gains built up inside the contract |
Phase one is a real advantage. Without a yearly tax drag, your earnings compound on themselves. Our article on tax-deferred growth in annuities shows how that adds up over time.
How are annuity withdrawals taxed?
For a nonqualified annuity, meaning one you bought with after-tax money, withdrawals come out of earnings first. Under IRS Publication 575, this earnings-first rule covers contracts bought after August 13, 1982.
- Earnings come out first. Say a hypothetical $100,000 premium grows to $130,000. If you take $20,000, the whole $20,000 is taxable because it all counts as earnings.
- Principal comes out last. Only after all earnings are withdrawn do you reach your original premium, which comes back tax-free.
- Ordinary income rates apply. The taxable part is taxed like wages, not at the lower capital gains rate.
Because gains come out first, the order of withdrawals matters. If you need cash in a year when your income is already high, a large withdrawal could push you into a higher bracket. Spreading withdrawals across several years can help.
Annuitized payments work differently. Each payment is split between taxable earnings and a tax-free return of your premium, using the annuity exclusion ratio.
What is the 10% early withdrawal tax?
Taxable amounts you take before age 59½ generally owe an extra 10% federal tax on top of regular income tax. This rule comes from IRC section 72(q).
- It applies to the taxable part only. Under earnings-first, early withdrawals are usually all taxable, so the extra tax often hits the full amount.
- There are exceptions. Death, disability and certain series of equal payments are among them. Confirm any exception with a tax professional before you count on it.
- It stacks with surrender charges. An early withdrawal can cost you a surrender charge, income tax and the 10% extra tax all at once.
What do heirs pay when they inherit an annuity?
Beneficiaries usually owe ordinary income tax on the deferred earnings inside the contract. Annuities do not get the step-up in basis that stocks and funds in a taxable brokerage account get at death.
An IRS revenue ruling from 2005 confirms this treatment. That makes an annuity a weaker choice for money you mainly plan to leave to heirs. Our guide to annuity beneficiary rules covers the payout choices heirs have.
How heirs take the money also matters. A lump sum puts all of the gain on one year’s tax return. Spreading payments out, where the contract and tax rules allow it, can keep each year’s bill smaller.
Does an annuity inside an IRA add a tax benefit?
No. You can hold an annuity inside an IRA, but the IRA already gives you tax deferral. You could get the same deferral with mutual funds, ETFs or other choices.
- No extra tax break. The annuity wrapper adds nothing to taxes inside a qualified account.
- It can add insurance features. Guaranteed income or a death benefit may still be worth having.
- Make sure you want those features. Pay for them only if they solve a real problem for you.
Withdrawals from an annuity held in a traditional IRA are generally fully taxable, because the money went in before tax. IRA early withdrawal and required minimum distribution rules apply instead of the nonqualified rules above. If an agent pitches tax deferral as the main reason to buy an annuity for your IRA, ask what else you are getting for the cost.
Annuity taxes depend on how the contract was funded, your state, your age and the contract itself. For any purchase of $50,000 or more, an hour with a CPA or tax professional is cheap compared with a surprise tax bill on a large withdrawal.
- How will this annuity be taxed for me, and for my beneficiaries?
- Is this a qualified or nonqualified purchase, and does that change how withdrawals are taxed?
- If I take money out before age 59½, what taxes and charges would I owe?
- If this goes inside an IRA, what am I paying for that the IRA does not already give me?
- Have I run this purchase past a CPA or tax professional?
Check your understanding
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Lesson 10 quiz: How annuities are taxed
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Common questions
Do I get a 1099 every year for annuity interest?
Not while the money stays inside a deferred annuity. You get a Form 1099-R in years when you take money out.
Is my original premium taxed again when I withdraw it?
Not in a nonqualified annuity, because you already paid tax on that money. In a traditional IRA annuity, the premium was usually pre-tax, so it is taxed when withdrawn.
Can I move to a different annuity without paying tax?
Often, yes. A 1035 exchange lets you move from one annuity to another without paying tax on the gain, though a new surrender period may start.
Taxes are one of the biggest hidden costs in an annuity, so get the answers in writing before you sign. Next, the course turns to your rights as an annuity buyer, now that you know how annuities are taxed.