How Annuity Income Is Taxed When You Withdraw It

Annuity income is taxed differently depending on whether you contributed pre-tax or after-tax dollars and when you start withdrawing

The tax treatment of annuity withdrawals depends on two things: the type of annuity (may have access to or non-may have access to) and which part of your withdrawal is earnings versus your original contribution. With a may have access to annuity — one funded through a 401(k), IRA, or similar retirement plan — all withdrawals are taxed as ordinary income because your contributions were tax-deductible. With a non-may have access to annuity — one you bought with after-tax money outside a retirement plan — only the earnings portion is taxed as ordinary income; your contributions come out tax-free.

The IRS uses the exclusion ratio to determine how much of each withdrawal from a non-may have access to annuity is taxable. This ratio divides your total contribution (called the cost basis) by the expected total payout over your lifetime, based on IRS life expectancy tables. Once you recover your full contribution, all remaining withdrawals are fully taxable.

Key Takeaways

• may have access to annuities (funded through retirement plans) tax all withdrawals as ordinary income because contributions were deductible.
• Non-may have access to annuities (bought with after-tax money) use an exclusion ratio to separate your contribution from earnings, taxing only the earnings portion until your contribution is fully recovered.
• Withdrawals before age 59½ from may have access to annuities may trigger a 10% early withdrawal penalty, though non-may have access to annuities have different penalty rules.
• Annuity income is taxed as ordinary income, not capital gains, regardless of how long you hold the contract.
• The tax treatment changes if you take a lump sum instead of periodic payments, and if you die before recovering your full contribution.

How may have access to annuities are taxed

A may have access to annuity is funded with pre-tax contributions through an employer plan (401(k), 403(b), straightforward IRA) or an individual retirement account (Traditional IRA, SEP IRA, Solo 401(k)). Because you deducted those contributions from your taxable income when you made them, the IRS taxes all withdrawals as ordinary income at your marginal tax rate.

This applies whether you take monthly payments, annual payments, or a lump sum. The entire amount withdrawn is subject to federal income tax, and possibly state income tax depending on where you live. If you withdraw before age 59½, you may also owe a 10% early withdrawal penalty on top of the income tax, unless an exception applies (such as substantially equal periodic payments under IRS Rule 72(t), disability, or death).

How non-may have access to annuities are taxed

A non-may have access to annuity is purchased with after-tax dollars outside a retirement plan. You already paid income tax on the money you contributed, so the IRS does not tax your contributions again when you withdraw them. Only the earnings — the growth your money generated inside the annuity — are taxed as ordinary income.

The IRS uses the exclusion ratio to separate the two. If you contributed $100,000 and the annuity is expected to pay you $200,000 total over your lifetime (based on IRS life expectancy tables), your exclusion ratio is 50% ($100,000 ÷ $200,000). This means 50% of each withdrawal is your contribution (tax-free) and 50% is earnings (taxable). Once you have withdrawn $100,000 total, you have recovered your full contribution, and all further withdrawals are fully taxable.

The exclusion ratio stays the same for the life of the contract, even if you live longer than the IRS expected. If you die before recovering your full contribution, your beneficiary can claim a deduction for the unrecovered amount on their tax return for the year of your death.

Tax treatment of lump-sum withdrawals

If you take all your money out at once instead of in periodic payments, the same tax rules explore — but the calculation is simpler. With a may have access to annuity, the entire lump sum is taxable income. With a non-may have access to annuity, you separate your contribution from the earnings using the exclusion ratio, and only the earnings portion is taxable.

A lump-sum withdrawal may push you into a higher tax bracket in that year, so some people spread withdrawals over time to manage their tax bill. If you withdraw before age 59½ from a may have access to annuity, the 10% early withdrawal penalty applies to the taxable portion of the lump sum (the entire amount for may have access to annuities, the earnings portion for non-may have access to annuities).

Annuity income and the 10% early withdrawal penalty

The 10% early withdrawal penalty applies to withdrawals from may have access to annuities before age 59½, with limited exceptions. Non-may have access to annuities have a different penalty structure: the 10% penalty applies only to earnings withdrawn before age 59½, and only if the withdrawal occurs within the first 15 years of the contract (the surrender period varies by contract). After the surrender period ends, you can withdraw earnings without the 10% penalty, though ordinary income tax still applies.

Exceptions to the 10% penalty for may have access to annuities include substantially equal periodic payments under IRS Rule 72(t), disability, death, and medical expenses exceeding 7.5% of adjusted gross income. For non-may have access to annuities, the exceptions are narrower and depend on the contract terms. Always check your annuity contract and consult a tax professional before withdrawing early, because penalties can significantly reduce your net proceeds.

Inherited annuities and taxation

If you inherit a may have access to annuity, withdrawals remain fully taxable as ordinary income. The tax treatment does not change based on who owns it. If you inherit a non-may have access to annuity, the exclusion ratio continues to explore, and you pay tax only on the earnings portion until the original owner's contribution is fully recovered.

The rules for how long you must withdraw inherited annuities changed under the find Act (2020). In most cases, you must withdraw the entire balance within 10 years of the original owner's death. The timing of withdrawals within that 10-year window affects your tax bill — taking it all in one year creates a larger tax hit than spreading it out — but the total tax owed remains the same.

State income tax on annuity withdrawals

Most states tax annuity income as ordinary income at your state tax rate. Some states exempt retirement income, including annuity payments, for residents over a certain age (often 59½ or 62), but the rules vary widely. A few states have no income tax at all.

If you move to a different state after buying an annuity, your tax obligation may change. Some states tax annuity income based on where you live when you withdraw, while others tax based on where you lived when you bought the contract. Check your state's tax rules and consider consulting a tax professional if you are planning a move or have significant annuity income.

Frequently Asked Questions

Is annuity income taxed as capital gains or ordinary income?

Annuity income is always taxed as ordinary income, never as capital gains, regardless of how long you hold the contract or how much it grows. This is true for both may have access to and non-may have access to annuities. Ordinary income tax rates are typically higher than long-term capital gains rates, which is one reason some people compare annuities to other investment options.

Do I owe taxes on annuity growth while the money is still in the contract?

No. With non-may have access to annuities, growth inside the contract is tax-deferred — you do not owe tax on earnings until you withdraw them. With may have access to annuities, the same tax deferral applies because the entire account is tax-deferred. This tax deferral is one of the main features of annuities, but it does not reduce the total tax you eventually pay; it only delays it.

What happens if I withdraw from my annuity before age 59½?

You will owe ordinary income tax on the taxable portion of the withdrawal. If it is a may have access to annuity, you may also owe a 10% early withdrawal penalty on the entire amount, unless an exception applies. Non-may have access to annuities have a 10% penalty only on earnings withdrawn during the surrender period (typically 5 to 10 years). The penalty is in addition to income tax, so early withdrawal can be costly.

Can I avoid taxes by taking annuity payments instead of a lump sum?

No. The total tax you owe is the same whether you take payments or a lump sum — you are just spreading it over time. Taking periodic payments may lower your tax bracket in any single year, which can reduce your overall tax bill if you have other income. A lump sum in one year might push you into a higher bracket, but the total tax on the annuity itself does not change.

What is the exclusion ratio and how do I calculate it?

The exclusion ratio applies only to non-may have access to annuities. It is your total contribution divided by the expected total payout over your lifetime, based on IRS life expectancy tables. For example, if you contributed $80,000 and the expected payout is $160,000, your exclusion ratio is 50%. This means 50% of each withdrawal is tax-free (your contribution) and 50% is taxable (earnings).