How Much Tax You Pay When You Withdraw Money From An Annuity

Tax on annuity withdrawals depends on whether you contributed pre-tax or after-tax money and when you withdraw

The tax you owe on an annuity withdrawal falls into two categories: ordinary income tax on the earnings portion, and possibly no tax on the portion that came from your own contributions. If you funded the annuity with pre-tax dollars (through an employer plan or traditional IRA), the entire withdrawal is taxed as ordinary income at your current tax rate. If you funded it with after-tax dollars, only the earnings are taxed; your contributions come out tax-free. The IRS calls this the exclusion ratio — it determines what percentage of each withdrawal is taxable.

Withdrawals before age 59½ from annuities tied to retirement accounts (like IRAs or 401(k)s) typically trigger a 10% early withdrawal penalty on top of ordinary income tax, with limited exceptions. Withdrawals from non-may have access to annuities (those not connected to a retirement plan) do not have an age restriction for penalty purposes, but earnings are still taxed as ordinary income whenever you take them out. The tax bill arrives when you file your return; the annuity company will send you a 1099-R form showing how much you withdrew and how much is taxable.

Key Takeaways

• Pre-tax annuity contributions are fully taxable when withdrawn; after-tax contributions are tax-free, and only earnings are taxed.
• The IRS exclusion ratio determines what percentage of each withdrawal counts as taxable earnings versus your own money returned to you.
• Withdrawals before age 59½ from retirement-account annuities (IRAs, 401(k)s) face a 10% penalty plus ordinary income tax, with some exceptions.
• Non-may have access to annuities have no age penalty, but earnings withdrawals are still taxed as ordinary income at your marginal rate.
• Your annuity company reports the withdrawal and taxable amount on Form 1099-R, which you use when filing your tax return.

How the exclusion ratio determines what portion of your withdrawal is taxed

The exclusion ratio is a fraction the IRS uses to separate your contributions from earnings in an annuity. It equals your total contributions divided by the total value of the annuity at the time you start withdrawals. If you put $50,000 into an annuity and it grew to $100,000, your exclusion ratio is 50% — meaning half of each withdrawal is your money (tax-free) and half is earnings (taxable).

This ratio stays the same for the life of the annuity, even as the account value changes. The IRS publishes life expectancy tables that also factor into the calculation for annuities that pay you for life, but the basic principle is the same: your contributions are recovered tax-free first, and everything beyond that is taxed. If you withdraw a lump sum instead of taking payments over time, the entire amount is subject to this same ratio — you do not get to choose which dollars come out first.

Tax rates on annuity earnings: ordinary income, not capital gains

Earnings withdrawn from an annuity are taxed as ordinary income, not as capital gains, regardless of how long you held the annuity or how much it grew. This is a key difference from stocks or mutual funds held outside a retirement account, where long-term gains often receive preferential tax rates. Your annuity earnings are taxed at your marginal tax bracket — the same rate as your wages or salary.

If you are in the 24% federal tax bracket and withdraw $10,000 in earnings from your annuity, you owe $2,400 in federal income tax on that amount (before state taxes, which vary by location). Some states also tax annuity withdrawals, and a few states exempt them entirely. Your tax situation also depends on your total income for the year, because withdrawals can push you into a higher bracket.

The 10% early withdrawal penalty for retirement-account annuities

If your annuity is funded through a retirement account — a traditional IRA, SEP-IRA, straightforward IRA, or 401(k) — withdrawals before age 59½ are subject to a 10% penalty on the taxable portion, in addition to ordinary income tax. This penalty applies to both your contributions and earnings if the account is pre-tax, or to earnings only if the account is after-tax (like a Roth IRA).

The IRS allows several exceptions to this penalty. The most common are: substantially equal periodic payments (SEPP), which let you withdraw a calculated amount each year without penalty; disability or medical hardship; and certain first-time home purchases (up to $10,000 lifetime from an IRA). If you take a withdrawal that does not meet an exception, you owe the 10% penalty when you file your tax return, even if the annuity company did not withhold it.

Non-may have access to annuities and the tax-free recovery of contributions

A non-may have access to annuity is one you bought with after-tax money outside of a retirement plan. These have no age restriction on withdrawals — you can take money out at any age without the 10% penalty. However, earnings are still taxed as ordinary income when withdrawn.

With a non-may have access to annuity, your contributions are recovered tax-free under the exclusion ratio. If you contributed $50,000 and the annuity is now worth $100,000, your first $50,000 in withdrawals are tax-free. After that, all withdrawals are taxable earnings. Some people use non-may have access to annuities specifically to access their contributions before 59½ without penalty, though the earnings portion would still be taxed.

Withholding and what happens at tax time

Your annuity company can withhold federal income tax from your withdrawal automatically. The amount withheld depends on the form you complete — you can choose 10%, 25%, or another percentage, or request no withholding. If you do not request withholding, you may owe taxes when you file your return, and you could face an underpayment penalty if you did not pay enough throughout the year.

The annuity company reports your withdrawal on Form 1099-R, which shows the gross amount withdrawn, the taxable portion, and any tax withheld. You receive this form by January 31 of the year after the withdrawal. You use the 1099-R to report the withdrawal on your tax return. If the company made an error on the form, contact them to request a corrected version before filing.

State taxes on annuity withdrawals vary widely

Federal income tax is only part of the picture. Some states tax annuity withdrawals at the same rate as other income, some offer partial exemptions, and a few exempt them entirely. Illinois, for example, exempts annuity income from state tax. New York taxes annuity withdrawals but allows a deduction for certain types of annuities. Other states have no income tax at all.

If you live in a state with income tax and withdraw from an annuity, check your state's tax department website or speak with a tax preparer about how your state treats the withdrawal. State tax withholding is separate from federal withholding, and you may need to request it separately or adjust your state tax payments to avoid a bill at tax time.

Frequently Asked Questions

Do I owe taxes on annuity withdrawals if I already paid taxes on the contributions?

No tax is owed on the portion of your withdrawal that represents your contributions. The exclusion ratio determines what percentage of each withdrawal is your contribution (tax-free) versus earnings (taxable). If you funded the annuity with after-tax dollars, you have already paid tax on that money once.

What is the difference between a lump sum withdrawal and taking payments over time?

The tax treatment is the same — the exclusion ratio applies either way. With a lump sum, you receive all the money at once and owe tax on the entire earnings portion in that year. With periodic payments, you spread the withdrawals over time, which may keep you in a lower tax bracket each year. The total tax owed is the same; only the timing and bracket impact differ.

Can I avoid the 10% penalty by rolling my annuity into an IRA?

Rolling an annuity into an IRA does not eliminate the 10% penalty for early withdrawals — the penalty applies to the IRA as well if you withdraw before 59½. However, a rollover can give you more control over the money and potentially lower fees. The penalty rules follow the money into the new account.

What happens if my annuity company withholds too much tax?

If too much tax was withheld, you receive the overpayment as a refund when you file your tax return. If too little was withheld and you owe additional tax, you pay the difference when you file. You can adjust your withholding going forward by submitting a new form to your annuity company.

Are annuity withdrawals subject to Medicare premium surcharges?

Yes. Annuity withdrawals count as income for the purpose of calculating Medicare Part B and Part D premiums if you are 65 or older. Higher income can trigger surcharges on your premiums. The IRS uses your modified adjusted gross income from two years prior, so a large withdrawal can affect your Medicare costs in the future.