Written by Jovan Johnson, Esq., Structured Settlement & Annuity Specialist
Updated September 4, 2026
Annuities let you defer taxes on growth, but the IRS still gets its share eventually — the exact rules depend on how the annuity was funded, how you withdraw the money, and, if you inherit one, who you inherited it from. Here’s how annuity taxation actually works.
If you’re weighing a sale of your annuity, taxes work differently at that point — see our page on annuity tax consequences when selling for that specific situation.
Are Annuities Taxed?
Yes — but only on the earnings, and only when money actually comes out of the contract. Growth inside an annuity isn’t taxed year to year the way a regular brokerage account’s dividends and capital gains would be; tax is deferred until you take a distribution. When that happens, annuity earnings are taxed as ordinary income, not at the more favorable long-term capital gains rate that applies to many other investments.
Qualified vs. Non-Qualified Annuities
Whether an annuity is qualified or non-qualified depends on what money funded it, and that determines how much of each withdrawal is taxable.
- Qualified annuities — funded with pre-tax money, typically rolled over from a 401(k), 403(b), or traditional IRA. Since that money was never taxed going in, the entire withdrawal — principal and earnings alike — is taxed as ordinary income when it comes out. Roth-funded annuities are the exception: qualifying withdrawals from a Roth 401(k) or Roth IRA-funded annuity are tax-free.
- Non-qualified annuities — funded with after-tax money. Only the earnings are taxable; your original principal (your “basis”) comes back tax-free, since you already paid tax on it once.
How Withdrawals Are Actually Taxed
The mechanics differ depending on whether you’re taking a lump sum or partial withdrawal from an unannuitized contract, or receiving regular payments after annuitizing.
Partial and Lump-Sum Withdrawals: the LIFO Rule
For withdrawals from a non-qualified annuity before you’ve annuitized it, the IRS applies a “last in, first out” (LIFO) rule: your earnings are treated as coming out first, and are fully taxable, before you touch any of your tax-free principal. In practice, this means an early partial withdrawal is often taxed more heavily than people expect, since you can’t choose to withdraw principal first to minimize the taxable portion.
Annuitized Payments: the Exclusion Ratio
Once you annuitize a non-qualified contract — converting it into a stream of regular payments — a different calculation applies: the exclusion ratio. This determines what percentage of each payment is a tax-free return of your principal versus taxable earnings, based on your investment in the contract, your life expectancy under IRS actuarial tables, and the length of the payout period.
If you outlive your life expectancy as calculated under those tables, all payments received after that point are fully taxable — the exclusion ratio effectively runs out once your original principal has been fully recovered.
The 10% Early Withdrawal Penalty
Withdrawing taxable annuity funds before age 59½ generally triggers a 10% additional tax on top of ordinary income tax, similar to early IRA withdrawals. Common exceptions include the annuitant’s death or disability, and “substantially equal periodic payments” taken under IRC § 72(t) — a structured payment plan designed to avoid the penalty. If one of these might apply to you, a tax professional can confirm whether you qualify before you withdraw.
Required Minimum Distributions
Qualified annuities inside a traditional IRA or 401(k) are subject to required minimum distributions (RMDs) — currently starting at age 73, rising to 75 by 2033 under the SECURE 2.0 Act. Non-qualified annuities funded with after-tax money outside a retirement account generally aren’t subject to RMDs.
Reporting Annuity Income
Annuity distributions are reported to you and the IRS on Form 1099-R. Box 1 shows your total distribution; the taxable amount (accounting for your basis, if any) is broken out separately. Keep these forms with your tax records, since the taxable-amount calculation can be complex, especially for older contracts.
Higher-Income Considerations: The Net Investment Income Tax
If your income is above certain thresholds, gains from a non-qualified annuity may also be subject to the 3.8% Net Investment Income Tax (NIIT) in addition to ordinary income tax. This doesn’t apply to qualified annuity distributions, which aren’t treated as net investment income. If you’re a higher earner, it’s worth discussing NIIT exposure with a tax professional before taking a large distribution.
Taxes on Inherited Annuities
The same basic qualified/non-qualified framework applies to beneficiaries: already-taxed principal isn’t taxed again, but untaxed principal and all earnings are.
One update worth knowing: for most non-spouse beneficiaries who inherit a qualified annuity (inside an IRA or similar account), the SECURE Act generally requires the full account to be distributed within 10 years, with those distributions taxed as ordinary income along the way. A surviving spouse has more flexibility, including the option to treat the account as their own. This 10-year rule is a meaningful change from older, more flexible “stretch” rules that used to apply more broadly — if you’ve inherited a qualified annuity, confirm which rules apply to your specific situation.
Annuity Tax FAQ
Is annuity income taxed as ordinary income or capital gains?
Ordinary income — annuity earnings don’t qualify for the lower long-term capital gains rate, regardless of how long the money has been growing inside the contract.
Do I pay taxes on an annuity every year, or only when I withdraw?
Only when you withdraw (or otherwise take a distribution). Growth inside the contract is tax-deferred, not taxed annually.
What tax form reports my annuity income?
Form 1099-R, issued by the insurance company, showing your total distribution and the taxable portion.
Can I avoid the 10% early withdrawal penalty?
Possibly — common exceptions include death, disability, and structured “substantially equal periodic payments” under IRC § 72(t). Confirm eligibility with a tax professional before relying on an exception.
Are taxes different if I sell my annuity instead of withdrawing from it?
Yes — see our dedicated page on annuity tax consequences when selling for that specific situation.
Sources
- IRS Publication 575 — Pension and Annuity Income
- IRS Tax Topic 410 — Pensions and Annuities
- 26 U.S.C. § 72 — Annuities; certain proceeds of endowment and life insurance contracts
About the Author: Jovan Johnson, Esq. is a structured settlement & annuity specialist with 12 years of experience, based in California. He has also practiced as an attorney in consumer and small business bankruptcy and debt settlement. Annuity Freedom has been helping clients sell annuity payments since 2017.
Disclaimer: This article is for informational purposes only and isn’t a substitute for advice from a licensed tax professional about your specific situation.