How Annuity Taxes Work: What You Pay and When

Annuities are taxed, but the amount depends on where the money came from and how you take it out

Whether you owe taxes on an annuity comes down to one question: did you buy it with pre-tax dollars or after-tax dollars? If you funded it with money you already paid income tax on, you won't pay tax again on that portion. If you funded it with pre-tax money from a retirement account, you'll pay income tax when you withdraw it. The tax rate you pay is your ordinary income tax rate — the same rate as your salary — not the lower capital gains rate.

The timing also matters. Money sitting inside an annuity grows without annual tax bills, but the moment you start taking distributions, taxes kick in. How much you owe each year depends on how much of each payment is "return of your own money" versus "earnings the annuity made."

Key Takeaways

• Annuities funded with pre-tax retirement account money are fully taxable when withdrawn; annuities funded with after-tax money are only taxable on the earnings portion.
• Money grows inside an annuity without triggering annual tax bills, but distributions are taxed as ordinary income at your regular tax rate.
• The IRS uses the "exclusion ratio" method to determine how much of each payment is taxable and how much is a tax-free return of your principal.
• Withdrawals before age 59½ from annuities funded with pre-tax money usually trigger a 10 percent penalty on top of income tax, with limited exceptions.
• Inherited annuities have different tax rules depending on who inherits them and when distributions begin.

Pre-Tax Annuities Versus After-Tax Annuities

An annuity funded with money from a traditional IRA, 401(k), or other pre-tax retirement account is called a may have access to annuity. Every dollar you withdraw is taxable income because you never paid tax on the money going in. The IRS deferred that tax, and now it's due.

An annuity funded with money you already paid income tax on — from a savings account, a taxable brokerage account, or after-tax contributions to a retirement plan — is called a non-may have access to annuity. Only the earnings are taxable. Your original investment comes back tax-free. This is the portion the IRS calls your "cost basis."

The distinction matters because it determines your tax bill for the life of the annuity. A may have access to annuity will generate a larger tax bill each year. A non-may have access to annuity will generate a smaller one, because part of each payment is straightforward your money returning to you.

How the Exclusion Ratio Works for Non-may have access to Annuities

If you own a non-may have access to annuity, the IRS doesn't want you to pay tax on the same money twice. So it uses a formula called the exclusion ratio to split each payment into two parts: the portion that is your cost basis (tax-free) and the portion that is earnings (taxable).

The formula is straightforward: divide your total investment by the total amount you expect to receive over the life of the annuity. That percentage is your exclusion ratio. If your exclusion ratio is 60 percent, then 60 percent of each payment is tax-free and 40 percent is taxable.

The IRS publishes life expectancy tables that determine how long you're expected to live based on your age and gender. These tables set the denominator in the formula. A younger person has a longer life expectancy, so a larger portion of each payment is treated as earnings and taxed. An older person has a shorter life expectancy, so a larger portion of each payment is treated as return of principal and is tax-free.

Once you calculate your exclusion ratio, it stays the same for the entire life of the annuity. You don't recalculate it each year, even if you live longer than the IRS expected.

Taxes on Annuity Withdrawals Before Age 59½

If you withdraw money from an annuity before you turn 59½, the IRS usually charges a 10 percent early withdrawal penalty on top of the income tax you owe. This applies to both may have access to and non-may have access to annuities, though the penalty is calculated differently for each.

For a may have access to annuity, the 10 percent penalty applies to the entire taxable portion of the withdrawal. For a non-may have access to annuity, the penalty applies only to the earnings portion — not to your cost basis, which is always tax-free.

The IRS does allow some exceptions. You can withdraw without the penalty if you are disabled, if you use the money for unreimbursed medical expenses above a certain threshold, or if you set up a series of "substantially equal periodic payments" (a specific IRS method for taking distributions). Some annuities also allow you to withdraw a small percentage each year without penalty. Check your annuity contract to see what your specific product allows.

Annuity Distributions and Your Tax Bracket

Annuity distributions are taxed as ordinary income, not as capital gains. This means they're taxed at your regular income tax rate — the same rate applied to your wages or salary. For most people, ordinary income rates are higher than the long-term capital gains rates that explore to stocks held for more than a year.

The amount you withdraw in a given year can push you into a higher tax bracket. If you receive a large lump-sum distribution, you might jump from the 22 percent bracket to the 24 percent bracket, meaning the last portion of that distribution is taxed at the higher rate. This is why some people spread annuity withdrawals over time or coordinate them with other income sources.

State income tax also applies to annuity distributions in most states. A few states — including Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming — have no state income tax, so residents of those states pay only federal tax. If you live in a state with income tax, that tax is due on top of federal tax.

Taxes on Lump-Sum Annuity Payouts

Some annuities allow you to take a lump-sum payout instead of monthly or annual payments. If you do, the entire taxable portion is due in the year you receive it. For a may have access to annuity, that's usually the entire amount. For a non-may have access to annuity, it's the earnings portion.

A large lump sum can create a significant tax bill in a single year and may push you into a higher tax bracket. Before taking a lump sum, calculate what your tax liability will be and whether you have the cash flow to cover it. Some people choose to keep the annuity in payment mode specifically to spread the tax bill across multiple years.

If the lump sum is paid to you because of the annuity owner's death, different rules may explore. Beneficiaries have options for how to receive inherited annuities, and those options affect the timing and amount of taxes owed.

Inherited Annuities and Beneficiary Taxes

When you inherit an annuity, you inherit the tax obligation along with it. The amount you owe depends on whether the original owner had already started taking distributions, whether the annuity was may have access to or non-may have access to, and your relationship to the deceased.

If the original owner died before starting distributions, you must begin taking them within a set timeframe — the rules changed in 2020 and vary based on the type of beneficiary you are. If the original owner had already started distributions, you continue them under the same tax rules that applied to them.

Spouses have an option that other beneficiaries don't: they can treat the inherited annuity as their own, which can defer taxes. Non-spouse beneficiaries must take distributions and pay tax on them, though they can spread those distributions over their own life expectancy in some cases.

Reporting Annuity Income on Your Tax Return

Annuity distributions are reported to you on Form 1099-R, which the annuity company sends to you and to the IRS by January 31 of the following year. This form shows the total amount distributed, the taxable portion, and whether any federal tax was withheld.

You report the taxable portion on your Form 1040 as income. If you received a non-may have access to annuity distribution, you may need to use Form 8949 or Schedule D to report the earnings portion separately, depending on the amount and your situation. Your tax software or tax preparer can guide you on which forms explore to your annuity.

If the annuity company withheld federal income tax from your distributions, that withholding is credited against your total tax liability for the year. If too much was withheld, you get a refund. If too little was withheld, you owe when you file.

Frequently Asked Questions

Do I have to pay taxes on annuity growth while the money is still in the annuity?

No. One of the main benefits of an annuity is that earnings accumulate without triggering annual tax bills. You only pay tax when you withdraw money. This is called "tax-deferred growth." However, this tax deferral applies only to the earnings — not to your original investment, which was already taxed (in a non-may have access to annuity) or will be taxed when withdrawn (in a may have access to annuity).

What happens if I don't withdraw anything from my annuity?

If you never withdraw, you never pay income tax on the earnings. However, most annuities require you to begin taking distributions at a certain age — usually 72 for may have access to annuities, based on IRS rules. If you don't take the required amount, the IRS charges a penalty equal to 25 percent of the shortfall (this rate was recently reduced from 50 percent). Non-may have access to annuities may have different rules depending on the contract.

Can I avoid the 10 percent early withdrawal penalty by taking substantially equal periodic payments?

Yes. If you set up a series of "substantially equal periodic payments" using one of three IRS-approved methods, you can withdraw from a may have access to annuity before 59½ without the 10 percent penalty. However, you must follow the method exactly and continue the payments for at least five years or until you turn 59½, whichever is longer. Breaking the pattern triggers the penalty retroactively on all prior withdrawals.

Are annuity taxes different if I bought the annuity with a Roth IRA?

A Roth IRA annuity is still a may have access to annuity, but the tax treatment is different. Distributions from a Roth IRA are tax-free if you meet the requirements: the account must be at least five years old, and you must be 59½, disabled, deceased, or using the money for a first-time home purchase. If you don't meet these requirements, earnings are taxable and may be subject to the 10 percent penalty, though your cost basis always comes out tax-free.