How Annuity Taxes Work: What You Pay and When

Annuity taxes depend on where the money came from and when you withdraw it

Whether an annuity is taxable depends almost entirely on what kind of money funded it. If you bought the annuity with pre-tax dollars from a workplace retirement plan or traditional IRA, the withdrawals are fully taxable as ordinary income. If you bought it with after-tax dollars from a regular savings account, only the earnings portion is taxable — the part of your withdrawal that represents your original money comes out tax-free. The tax treatment does not change based on the annuity company or the type of annuity contract itself; it follows the money backwards to its source.

The timing of when you withdraw money also matters. If you withdraw before age 59½ from an annuity funded with pre-tax retirement dollars, you typically owe a 10 percent early withdrawal penalty on top of ordinary income tax, unless an exception applies. Withdrawals at 59½ or later have no penalty, though the income tax still applies. Annuities funded with after-tax money have no age penalty at all, though earnings still get taxed when withdrawn.

Key Takeaways

• Pre-tax annuities (funded from 401(k)s, traditional IRAs, or other retirement plans) tax all withdrawals as ordinary income at your current tax rate.
• After-tax annuities (funded with money you already paid taxes on) tax only the earnings portion; your original contributions return tax-free.
• Withdrawals before age 59½ from pre-tax annuities trigger a 10 percent early withdrawal penalty unless a specific exception applies, such as substantially equal periodic payments.
• The annuity company reports taxable amounts to the IRS on Form 1099-R, and you report them on your tax return; the tax is not withheld automatically unless you request it.

Pre-tax annuities: full taxation on withdrawal

A pre-tax annuity is one you funded with money that was never taxed — typically a rollover from a 401(k), 403(b), or traditional IRA. Every dollar you withdraw is taxable as ordinary income in the year you withdraw it. If you withdraw $10,000 and you are in the 22 percent federal tax bracket, you owe $2,200 in federal income tax on that withdrawal, plus any state income tax your state charges.

This applies whether you take a lump sum, monthly payments, or an income stream that lasts your lifetime. The annuity company does not automatically withhold taxes — you can request withholding when you set up the annuity, but if you do not, you are responsible for paying the tax when you file your return. Many people request 10 to 20 percent withholding to avoid a large bill at tax time.

If you withdraw before age 59½, you also owe a 10 percent penalty on the taxable amount. So a $10,000 withdrawal at age 50 would cost you $1,000 in penalty plus the ordinary income tax. The penalty applies to the entire withdrawal amount, not just the earnings.

After-tax annuities: only earnings are taxed

An after-tax annuity is one you funded with money you already paid taxes on — money from a savings account, a brokerage account, or a non-retirement source. When you withdraw money, the IRS uses the exclusion ratio to determine what portion is taxable. The exclusion ratio divides your original contribution by the total value of the annuity at the time you start withdrawals. That percentage of each payment is your contribution and comes out tax-free; the rest is earnings and is taxable.

For example, if you put $50,000 into an after-tax annuity and it grew to $70,000 by the time you start withdrawals, your exclusion ratio is 50,000 ÷ 70,000, or about 71 percent. If you withdraw $1,000, about $714 is tax-free and $286 is taxable. Once you have withdrawn your entire $50,000 contribution, all further withdrawals are fully taxable as earnings.

After-tax annuities have no early withdrawal penalty, regardless of your age. You can withdraw at 40, 50, or 55 with no 10 percent penalty. You still owe income tax on the earnings portion, but the penalty does not explore.

How the IRS tracks and reports annuity income

The annuity company reports your withdrawals to the IRS on Form 1099-R, which shows the total amount withdrawn and the taxable portion. You receive a copy and report the taxable amount on your tax return, usually on Form 1040. The form also notes whether the withdrawal was before age 59½ and whether a penalty applies.

If you requested tax withholding, the company withholds that amount from each payment and reports it separately on the 1099-R. The withheld amount is credited against your total tax liability for the year. If too much was withheld, you get a refund; if too little, you owe when you file.

You are responsible for reporting the income even if the company makes an error on the 1099-R. If the form shows the wrong taxable amount, you can file Form 8949 or attach a statement to your return explaining the discrepancy, but the IRS will match the 1099-R to your return automatically, so errors often trigger a notice.

The 10 percent early withdrawal penalty and its exceptions

The 10 percent penalty on pre-tax annuities before age 59½ is a federal rule, separate from income tax. It applies to the full taxable amount of the withdrawal. Some states also charge an additional penalty, though most do not.

Several exceptions exist. If you set up substantially equal periodic payments (SEPP) under IRS Rule 72(t), you can withdraw from a pre-tax annuity at any age without penalty, as long as you follow the formula and do not change the payment amount for five years or until age 59½, whichever is longer. If you become disabled or face a medical hardship, you may be able to withdraw without penalty if you meet the IRS definition. Death also removes the penalty — beneficiaries who inherit an annuity and withdraw it do not owe the early withdrawal penalty, though they do owe income tax.

Annuities funded through a Roth IRA or Roth conversion have different rules. Roth annuities allow you to withdraw your contributions at any age without tax or penalty, though earnings withdrawals before 59½ may be penalized.

State income tax on annuity withdrawals

Federal income tax is only part of the picture. Most states that charge income tax also tax annuity withdrawals at the same rate they tax other income. A few states — including Pennsylvania, Tennessee, and Illinois — exempt annuity income from state tax under certain conditions, usually if the annuity was purchased with pre-tax retirement dollars. The rules vary significantly by state and by the type of annuity contract.

If you live in a state with income tax and withdraw from an annuity, ask the annuity company whether state withholding is available. Some companies offer it; others do not. If it is not available and you expect a state tax bill, you may need to make estimated tax payments to avoid penalties.

Inherited annuities and beneficiary tax rules

When you inherit an annuity, the tax treatment depends on the type of annuity and your relationship to the original owner. If you inherit a pre-tax annuity, the withdrawals are taxable to you as ordinary income, just as they would have been to the original owner. If you inherit an after-tax annuity, the exclusion ratio applies to your withdrawals as well.

The original owner's death does not trigger a tax bill on the full remaining balance — you only pay tax as you withdraw. However, federal law now requires most non-spouse beneficiaries to withdraw the entire annuity within ten years of the owner's death. The withdrawals are taxable, but you can spread them across the ten-year period to manage the tax impact.

Spouses who inherit an annuity have more flexibility. A spouse can treat the inherited annuity as their own, roll it into their own IRA, or keep it as an inherited annuity with different withdrawal rules. Each option has different tax consequences.

Frequently Asked Questions

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

No. Annuities grow tax-deferred, meaning you do not owe tax on the earnings until you withdraw them. This applies to both pre-tax and after-tax annuities. The tax is deferred until the moment you take money out.

What if I bought an annuity with a mix of pre-tax and after-tax money?

The exclusion ratio applies to the after-tax portion. You will need to track how much of the original purchase price came from each source. The annuity company should help you calculate this, but it is your responsibility to report it correctly to the IRS.

Can I avoid the 10 percent penalty by taking small withdrawals?

Not by taking small withdrawals alone. The penalty applies to any withdrawal before 59½ from a pre-tax annuity, regardless of size. The exception is substantially equal periodic payments under Rule 72(t), which requires a specific formula and commitment to regular payments.

Does the annuity company automatically withhold taxes from my payments?

No, unless you request it. When you set up the annuity or begin withdrawals, you can elect to have taxes withheld at a percentage you choose. If you do not elect withholding, you are responsible for paying the tax when you file your return or through estimated tax payments.

What happens if I surrender the annuity early?

Surrendering (cashing out) an annuity is treated as a full withdrawal. You owe income tax on the taxable portion and the 10 percent early withdrawal penalty if you are under 59½ and it is a pre-tax annuity. Many annuity contracts also charge a surrender fee if you withdraw before a certain period (often five to ten years), which reduces the amount you receive but is separate from the tax and penalty.