How are annuities taxed? Annuities grow tax-deferred, and the gains are taxed as ordinary income when you take money out. How much of each payment is taxable depends on whether you bought the annuity with pre-tax or after-tax money.
Is Annuity Income Taxable?
Yes, annuity income is taxable, but usually not all of it.
- Qualified annuity (IRA, 401(k) or 403(b) money): every dollar you receive is taxable as ordinary income.
- Non-qualified annuity (after-tax savings): only the earnings are taxable. Your original premium comes back tax-free.
- Lifetime income payments: for non-qualified money, the exclusion ratio splits each check into a tax-free part and a taxable part.
- Before age 59½: the taxable part may also owe a 10% IRS penalty.
- Annuity growth is tax-deferred. No tax is owed until you take withdrawals, however 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 taxes are widely misunderstood, and mistakes cost money. Four rules do most of the work:
- In your favor: growth is tax-deferred, and a 1035 exchange moves money between annuities tax-free.
- Against you: gains are taxed as ordinary income, not capital gains, and a 10% penalty applies before age 59½.
The Fundamental Rule: Tax-Deferred Growth
Money inside an annuity grows tax-deferred. You pay no income tax on interest, dividends or gains inside the contract until you take a distribution. There is no annual 1099 and no tax drag on compounding.
- Fixed annuity: credited interest compounds without an annual tax bill.
- Variable annuity: dividends and capital gains inside the subaccounts compound untaxed.
- Bank CD or brokerage account, by contrast: you get a 1099 every year and owe tax on that year’s earnings, even if you don’t spend them.
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 bought with personal savings are non-qualified. If you rolled a 401(k) or traditional IRA into an annuity, it is qualified, and everything that comes out is fully taxable. Our guide to qualified vs. non-qualified annuities covers the differences in detail.
The LIFO Rule: Gains Come Out First
For non-qualified annuities, the IRS applies LIFO (last in, first out) to withdrawals. 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 main tax drawback of annuities. Taxable gains you withdraw are ordinary income, taxed at the same rates as wages. Stocks or funds held more than a year in a brokerage account get the lower long-term capital gains rates instead.
| 2026 Taxable Income (Single) | Long-Term Capital Gains Rate | Ordinary Income Rates in This Range |
|---|---|---|
| Up to $49,450 | 0% | 10% to 12% |
| $49,451 to $545,500 | 15% | 12% to 35% |
| Over $545,500 | 20% | 35% to 37% |
Source: IRS Rev. Proc. 2025-32 inflation adjustments for tax year 2026.
If you would otherwise pay 0% or 15% on capital gains, ordinary income treatment is a real cost. That is why variable annuities holding stock funds are often a poor tax choice for middle-bracket investors who could hold index funds in a taxable account.
Annuity tax deferral works best in two situations:
- High bracket now: you are deferring tax that you would otherwise pay today at a high ordinary rate.
- Lower bracket later: you expect to be in a meaningfully lower bracket when you withdraw.
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)
- Payments from an immediate annuity
- Substantially equal periodic payments (Section 72(q) for non-qualified annuities, 72(t) for IRAs)
This penalty is why annuities rarely suit savers under 55. Surrender charges from the insurer plus the IRS penalty make early access expensive. See our full annuity withdrawal rules for the details.
How Annuitized Payments Are Taxed
When you turn an annuity into income payments (annuitization), taxes follow the exclusion ratio. It sets how much of each payment is a tax-free return of principal and how much is taxable earnings.
- Non-qualified annuity: exclusion ratio = your investment ÷ expected total payments. If you invested $100,000 and expect $200,000 in payments, 50% of each check is tax-free.
- After you recover your investment: once your full $100,000 has come back, later payments are fully taxable.
- Qualified annuity (IRA or 401(k) money): no exclusion ratio applies, so the entire payment is taxable.
The 1035 Exchange: Moving Without Triggering Taxes
A 1035 exchange, named for the tax code section, moves an annuity into a new annuity without counting as a taxable distribution. You owe no tax and no penalty, even if the old annuity has large 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
The main rules:
- Annuity to annuity: you cannot 1035 an annuity into a life insurance policy.
- Direct transfer: the money goes carrier to carrier and never touches your hands.
- Same owner: the old and new contracts must have the same owner.
Follow our step-by-step 1035 exchange guide before you move money.
Required Minimum Distributions (RMDs)
If your annuity sits inside a qualified account (an IRA or 401(k) rollover), it is subject to required minimum distributions starting at age 73. The annuity RMD rules apply to the contract’s 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 to inherited annuities, whatever the beneficiary’s age
- For a non-qualified annuity, the beneficiary generally must empty it within 5 years or start lifetime payments within one year of the death
- For an annuity inside an inherited IRA, most non-spouse beneficiaries must empty it within 10 years under the SECURE Act
Spouses have more options, including continuing the contract as their own. Our annuity beneficiary rules guide walks through each choice.
That is how annuities are taxed: tax-deferred while they grow, and taxed as ordinary income on the gains when the money comes out.
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 each year, so 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.
