- Annuity growth is tax-deferred — no taxes are owed until you take withdrawals, regardless of how long the money compounds inside the contract.
- When you withdraw, gains come out first (LIFO rule) and are taxed as ordinary income — not at the lower capital gains rate.
- Withdrawals before age 59½ trigger a 10% IRS early withdrawal penalty on top of regular income tax.
- Non-qualified annuities (funded with after-tax dollars) return principal tax-free. Qualified annuities (funded with pre-tax IRA/401k money) are fully taxable on withdrawal.
- A 1035 exchange allows you to move money between annuities without a taxable event — keeping the tax deferral running indefinitely.
Annuity taxation is one of the most misunderstood aspects of these products — and getting it wrong costs money. There are two favorable tax rules: growth is tax-deferred, and a 1035 exchange is tax-free. There are two unfavorable ones: gains are taxed as ordinary income (not capital gains), and the 10% early withdrawal penalty applies before age 59½.
Whether an annuity makes sense for your situation often comes down to this tax math. This guide explains every rule clearly.
The Fundamental Rule: Tax-Deferred Growth
Money inside an annuity grows tax-deferred. You pay no income tax on interest, dividends, or capital gains generated inside the contract — ever — until you take a distribution. No annual 1099. No tax drag on compounding.
This is the central tax benefit of any annuity. For a fixed annuity, it means your credited interest compounds without being reduced by an annual tax payment. For a variable annuity, dividends and capital gains inside the subaccounts compound without taxation.
Compare that to a taxable brokerage account or bank CD, where you receive a 1099 every year and owe taxes on that year’s earnings — whether you spend the money or not. The compounding effect of deferral is real and measurable over long periods.
Qualified vs. Non-Qualified Annuities
How your annuity is taxed on withdrawal depends critically on whether it’s qualified or non-qualified:
| Type | Funded With | Tax Treatment at Withdrawal |
|---|---|---|
| Non-qualified annuity | After-tax money (personal savings) | Principal returned tax-free; gains taxed as ordinary income |
| Qualified annuity (IRA/401k) | Pre-tax money (IRA rollover, 401k) | Entire withdrawal taxed as ordinary income (no tax-free basis) |
Most annuities purchased with personal savings are non-qualified. If you rolled a 401(k) or traditional IRA into an annuity, it’s qualified — and everything that comes out is fully taxable.
The LIFO Rule: Gains Come Out First
For non-qualified annuities, the IRS applies LIFO (Last In, First Out) accounting to withdrawals. This means your earnings — the “last in” — are treated as coming out first, before your original principal.
Example: You deposit $100,000 into a non-qualified MYGA. After 5 years, your account has grown to $132,000. You withdraw $15,000.
- The IRS considers the first $32,000 withdrawn to be earnings (fully taxable)
- Your $15,000 withdrawal is therefore fully taxable as ordinary income
- Only after you’ve withdrawn all $32,000 in earnings would the remaining $100,000 of principal come out tax-free
This matters because it means partial withdrawals early in the contract are typically fully taxable. Your tax-free basis (original principal) comes back only after all gains have been distributed.
Ordinary Income Rate — Not Capital Gains
This is the critical tax disadvantage of annuities compared to taxable investment accounts. When you withdraw from an annuity, the taxable gains are treated as ordinary income — the same rate as your wages.
In contrast, assets held in a taxable brokerage account for more than a year are taxed at long-term capital gains rates:
| Tax Filing Status / Income | Long-Term Capital Gains Rate | Ordinary Income Rate (top end) |
|---|---|---|
| Single, under $47,025 | 0% | 22% |
| Single, $47,025–$518,900 | 15% | 22%–35% |
| Single, over $518,900 | 20% | 37% |
For investors who would otherwise pay 0% or 15% on capital gains, an annuity’s ordinary income treatment at withdrawal is a significant disadvantage. This is why variable annuities — which invest in equities that would otherwise generate capital gains — are often a poor tax choice for investors in middle brackets who could simply hold index funds in a taxable account.
The annuity tax calculus works best when: (a) you’re deferring taxes that would otherwise be paid at high ordinary income rates today, and (b) you’ll be in a meaningfully lower bracket at withdrawal.
The 10% Early Withdrawal Penalty
Like IRAs and 401(k)s, annuities carry a 10% IRS penalty on taxable withdrawals taken before age 59½. The penalty applies to the taxable portion (gains) — not your original principal in a non-qualified annuity.
Exceptions to the 10% penalty include:
- Death of the annuity owner
- Disability (as defined by the IRS)
- Annuitization (converting to a stream of substantially equal periodic payments)
- Substantially Equal Periodic Payments (SEPP / 72(t) distributions)
This penalty is why MYGAs and other annuities are generally not appropriate for investors under 55 — the combination of surrender charges (from the insurer) and the IRS penalty makes early access expensive.
How Annuitized Payments Are Taxed
When you convert an annuity into a stream of income payments (annuitization), taxation follows the exclusion ratio — a formula that determines what portion of each payment is return of principal (tax-free) vs. earnings (taxable).
For a non-qualified annuity: the exclusion ratio = your investment in the contract ÷ expected total payments. If you expect to receive $200,000 in total payments and your original investment was $100,000, 50% of each payment is tax-free (return of basis) and 50% is taxable.
For qualified annuities (IRA/401k money): no exclusion ratio applies — the entire payment is taxable, since no after-tax money was contributed.
The 1035 Exchange: Moving Without Triggering Taxes
A 1035 exchange (named for the IRS code section) allows you to transfer an annuity to a new annuity without the transfer being treated as a taxable distribution. No taxes, no penalty — even if your old annuity has significant unrealized gains.
Common uses:
- Rolling a maturing MYGA into a new MYGA at a higher rate
- Moving from an old high-fee variable annuity to a lower-cost product
- Transferring a fixed annuity to a fixed index annuity for more growth potential
Rules: The exchange must be annuity-to-annuity (you can’t 1035 into a life insurance policy). It must be a direct transfer between carriers — the money cannot touch your hands. And the policies must have the same owner.
Step-by-step 1035 exchange guide →
Required Minimum Distributions (RMDs)
If your annuity is inside a qualified account (IRA, 401k rollover), it is subject to Required Minimum Distributions starting at age 73. The RMD rules apply to the annuity’s account value just as they would to any IRA asset.
Non-qualified annuities are not subject to RMDs. You can let a non-qualified MYGA or fixed annuity continue compounding tax-deferred past age 73 with no forced distributions.
Inherited Annuities: How Beneficiaries Are Taxed
When an annuity owner dies and a non-spouse beneficiary inherits the contract:
- The beneficiary owes income tax on the gains (but not the original principal, for non-qualified contracts)
- The 10% early withdrawal penalty does not apply — the age 59½ rule doesn’t apply to inherited annuities
- The beneficiary typically must take distributions within 5 years or over their life expectancy, depending on the contract and their election
Spouses have additional options including continuing the contract as their own.
Frequently Asked Questions: How Are Annuities Taxed?
Is annuity income taxed as ordinary income?
Yes. Gains withdrawn from an annuity are taxed as ordinary income at your current tax rate — not at the lower long-term capital gains rate. This is one of the key tax disadvantages of annuities compared to taxable investment accounts holding stocks or index funds for the long term.
Do you pay taxes on annuity withdrawals?
Yes, on the gains. For a non-qualified annuity, your original principal returns tax-free — but all earnings are taxable as ordinary income when withdrawn. For qualified annuities (funded with IRA/401k money), the entire withdrawal is taxable since the money was never taxed going in.
What is the tax penalty for early withdrawal from an annuity?
The IRS charges a 10% penalty on the taxable portion of any annuity withdrawal taken before age 59½. This is in addition to regular income tax on the gains. The penalty does not apply to inherited annuities, disability situations, or annuitized payments structured as substantially equal periodic payments.
Are annuities tax-deferred or tax-free?
Tax-deferred, not tax-free. Growth inside an annuity is not taxed annually — it compounds without drag. But taxes are owed when you withdraw. A Roth IRA, by contrast, provides tax-free growth and tax-free withdrawals. Annuities do not offer the Roth tax-free treatment.
What is a 1035 exchange?
A 1035 exchange is a tax-free transfer of funds from one annuity to another. Named for IRS Code Section 1035, it allows you to move your entire balance — including accumulated gains — to a new annuity without triggering income tax or penalty. The exchange must be a direct carrier-to-carrier transfer.
Do non-qualified annuities have RMDs?
No. Required Minimum Distributions only apply to qualified accounts (IRA, 401k). A non-qualified annuity funded with after-tax money has no RMD requirement — you can let it continue compounding tax-deferred as long as you wish, with no forced withdrawals at any age.
