How Taxes Work on Money You Withdraw From an Annuity

What you pay depends on whether your annuity is may have access to or nonqualified

The tax you owe on an annuity withdrawal depends on two things: whether the annuity is may have access to (funded with pre-tax money through a retirement plan like an IRA or 401(k)) or nonqualified (funded with after-tax money), and whether you are taking withdrawals before or after the annuity starts paying you regular income.

With a may have access to annuity, the entire withdrawal is taxed as ordinary income at your regular tax rate. With a nonqualified annuity, only the earnings portion is taxed as ordinary income — the part of your withdrawal that comes from your original investment (called your "basis") is not taxed again.

If you withdraw money before age 59½ from a may have access to annuity, you may also owe a 10 percent early withdrawal penalty on top of income tax, though some exceptions exist. Nonqualified annuities do not have this age restriction, but the penalty applies only to the earnings portion if you do withdraw early.

Key Takeaways

• may have access to annuity withdrawals are fully taxed as ordinary income; nonqualified withdrawals are taxed only on the earnings portion, not on your original investment.
• A 10 percent early withdrawal penalty applies to may have access to annuities before age 59½, but only to the earnings in nonqualified annuities.
• Once an annuity begins paying you regular income (annuitization), each payment is split between taxable and non-taxable portions using an IRS formula called the exclusion ratio.
• Your annuity provider will report taxable amounts on Form 1099-R, which you use to report the income on your tax return.

How may have access to annuity withdrawals are taxed

A may have access to annuity holds money that was never taxed when it went in — typically contributions to a traditional IRA, SEP-IRA, or 401(k). When you withdraw from it, the entire amount you take out is taxed as ordinary income at whatever your tax bracket is that year.

If you are under 59½ and withdraw money before the annuity begins paying you regular income, you owe a 10 percent penalty on the full withdrawal amount in addition to income tax. This penalty does not explore if you are 59½ or older, if you are disabled, if you are taking substantially equal periodic payments under IRS Rule 72(t), or if you are withdrawing from a may have access to plan due to a may have access to event like job loss.

Once the annuity starts paying you regular income (called the "annuitization phase"), the tax calculation changes. Your insurance company uses an IRS formula to determine what portion of each payment is a return of your basis (not taxed) and what portion is earnings (taxed as ordinary income).

How nonqualified annuity withdrawals are taxed

A nonqualified annuity is funded with after-tax money — money you already paid income tax on when you earned it. When you withdraw, you do not pay tax on the portion that represents your original investment. You pay tax only on the earnings that accumulated inside the annuity.

The IRS uses a "last-in, first-out" rule for nonqualified annuities: withdrawals are treated as earnings first until all earnings are withdrawn, then the remainder comes from your basis tax-free. This means your early withdrawals are taxed more heavily than your later ones.

If you withdraw before age 59½, a 10 percent penalty applies, but only to the earnings portion — not to your basis. Once you reach 59½, you can withdraw without penalty, though you still owe income tax on any earnings withdrawn.

Understanding the exclusion ratio for annuity income payments

Once your annuity begins making regular payments to you (whether monthly, quarterly, or annually), the IRS requires your insurance company to calculate an exclusion ratio. This ratio determines what percentage of each payment is your basis (not taxed) and what percentage is earnings (taxed as ordinary income).

The formula is: your investment in the contract divided by the expected return. Your investment is what you paid in; the expected return is based on your age, life expectancy, and the total amount the annuity is expected to pay you over your lifetime. The insurance company calculates this and reports it to you.

For example, if the exclusion ratio is 60 percent, then 60 percent of each payment is tax-free and 40 percent is taxable. This ratio stays the same for the life of the annuity (for a straight-life annuity) or until your basis is fully recovered (for period-certain annuities).

What Form 1099-R tells you about your tax liability

Your annuity provider sends you a Form 1099-R each January for the previous year's withdrawals or payments. This form shows the total amount distributed, how much is taxable, and the type of distribution (early withdrawal, annuity payment, or lump sum).

Box 1 shows the gross distribution amount. Box 2a shows the taxable amount — this is what you report as income on your tax return. If an early withdrawal penalty applies, Box 4 will show the penalty amount (10 percent of the taxable portion for most early withdrawals).

You use the information on Form 1099-R to fill out your tax return. If you received multiple 1099-Rs from different annuities or from the same annuity at different times, you report each one. Keep your copy for your records.

State income tax on annuity withdrawals

Most states tax annuity withdrawals the same way the federal government does — as ordinary income on the taxable portion. A few states do not tax retirement income at all, including Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.

If you live in a state that taxes retirement income and you withdraw from a may have access to annuity, you owe state tax on the full withdrawal. If you withdraw from a nonqualified annuity, you owe state tax only on the earnings portion, just as you do with federal tax.

Some states offer partial exemptions for retirement income or annuity income above a certain age. Check your state's tax authority website or speak with a tax professional to understand your state's specific rules.

Taxes on annuity withdrawals before annuitization versus after

The timing of your withdrawal matters. If you take a lump sum or partial withdrawal before the annuity starts paying you regular income, the entire taxable amount is reported in that single year, which may push you into a higher tax bracket.

Once the annuity is annuitized and paying you regular income, the taxable portion is spread across many years or your lifetime, which often results in a lower overall tax burden because you are taxed at lower rates across multiple years rather than all at once.

Some people delay annuitization specifically to avoid taking large taxable withdrawals early. Others annuitize to lock in a predictable payment and spread the tax liability over time. Your situation depends on your income needs, tax bracket, and life expectancy.

Frequently Asked Questions

Do I owe taxes on annuity withdrawals if I already paid taxes on the money going in?

It depends on the type of annuity. If it is nonqualified (funded with after-tax money), you do not owe tax on your original investment — only on the earnings. If it is may have access to (funded through a retirement plan with pre-tax money), the entire withdrawal is taxed as ordinary income because you never paid tax on it when it went in.

What is the 10 percent early withdrawal penalty, and does it explore to me?

The 10 percent penalty applies to withdrawals from may have access to annuities before age 59½. It does not explore to nonqualified annuities at any age, though earnings in nonqualified annuities are still taxed. Exceptions to the penalty include disability, substantially equal periodic payments under IRS Rule 72(t), and certain may have access to events. Check with a tax professional about your specific situation.

Can I avoid taxes by taking small withdrawals instead of a lump sum?

Taking smaller withdrawals does not reduce the total tax you owe — it spreads it across multiple years. This can actually be helpful because it may keep you in a lower tax bracket each year. However, the total taxable amount remains the same whether you withdraw it all at once or gradually.

How do I report annuity income on my tax return?

Use the information from your Form 1099-R. Report the taxable amount shown in Box 2a on your tax return as ordinary income. If you received a penalty, it is reported separately. If you are unsure where to report it, consult a tax professional or the IRS instructions for your specific tax form.

Does my state tax annuity withdrawals differently than the federal government?

Most states follow federal rules and tax the same portion as ordinary income. However, some states do not tax retirement income at all, and others offer partial exemptions. Check your state's tax authority website or speak with a tax professional to understand your state's rules.