How Annuity Income Gets Taxed

Yes, most annuity income is taxable, but the amount you owe depends on how much of each payment is earnings versus your own money returned

When you receive payments from an annuity, the IRS taxes the portion that represents investment gains — not the portion that is your original contribution being paid back. If you bought an annuity with $100,000 of your own money and it has grown to $150,000, only the $50,000 gain is taxable as you withdraw it. The $100,000 return of your principal is not taxed again.

The tax treatment changes depending on whether you bought the annuity with pre-tax money (like from a traditional IRA or 401(k)) or after-tax money (like from a regular savings account). It also matters whether you are still in the accumulation phase — where the annuity is growing but you have not started taking payments yet — or in the payout phase, where you are receiving regular income.

Key Takeaways

• Annuity payments are taxed only on the earnings portion, not on your original contribution, unless the annuity was funded with pre-tax retirement money.
• If you funded an annuity with money from a traditional IRA or 401(k), the entire payment is taxable as ordinary income.
• If you funded an annuity with after-tax money from a savings account, you pay tax only on the gain, using the exclusion ratio method to determine how much of each check is taxable.
• Withdrawals before age 59½ from annuities funded with pre-tax money may trigger a 10 percent early withdrawal penalty on top of income tax.
• Annuities held inside a Roth IRA follow Roth rules: may have access to withdrawals are tax-free, and non-may have access to withdrawals are taxed differently.

How the exclusion ratio works for after-tax annuities

If you bought an annuity with money you already paid taxes on — such as savings from your checking account — the IRS lets you recover your contribution tax-free. The formula is called the exclusion ratio, and it divides your original investment by the total amount you expect to receive over the life of the annuity.

Suppose you invested $100,000 in an annuity, and the insurance company calculates you will receive $200,000 total over your lifetime. Your exclusion ratio is 50 percent ($100,000 ÷ $200,000). That means 50 percent of each monthly payment is your money returned tax-free, and 50 percent is taxable earnings. If your monthly payment is $1,000, you report $500 as income and $500 is not taxable.

The exclusion ratio stays the same for the life of the annuity, even if you live longer than expected and receive more total money. Once you have recovered your full $100,000 contribution, all remaining payments become fully taxable.

Tax treatment of pre-tax retirement account annuities

If you funded the annuity with money from a traditional IRA, SEP-IRA, straightforward IRA, or 401(k), the entire payment is taxable as ordinary income in the year you receive it. There is no exclusion ratio because you did not pay taxes on the money when you contributed it to the retirement account.

The insurance company will send you a Form 1099-R each year showing the total amount paid to you. You report this on your tax return as income. The tax rate you pay depends on your overall income that year and your tax bracket.

If you withdraw money before age 59½, you may also owe a 10 percent early withdrawal penalty on the taxable portion, in addition to regular income tax. Some exceptions exist — such as if you are disabled, receiving substantially equal periodic payments under IRS Rule 72(t), or withdrawing from a Roth IRA — but most early withdrawals trigger the penalty.

Annuities inside Roth IRAs and other retirement accounts

An annuity held inside a Roth IRA follows Roth rules, not annuity rules. If you have owned the Roth IRA for at least five years and are age 59½ or older, withdrawals are tax-free. If you withdraw before meeting both conditions, the earnings portion is taxable and may be subject to the 10 percent early withdrawal penalty.

Annuities inside a traditional IRA or 401(k) are treated as pre-tax annuities — the entire payment is taxable. The fact that it is held inside a retirement account does not change the tax treatment; it only means the annuity is subject to required minimum distributions (RMDs) starting at age 73 (as of 2023, under current law).

What happens during the accumulation phase

While an annuity is growing and you have not yet started taking payments, you do not owe tax on the earnings each year. This is called tax-deferred growth. The money compounds without annual tax bills, which is one reason annuities appeal to some savers.

However, if you withdraw money during the accumulation phase — before the payout phase begins — the earnings are taxable in the year of withdrawal. If you are under 59½ and the annuity was funded with pre-tax retirement money, you may also owe the 10 percent early withdrawal penalty. After-tax annuities follow the exclusion ratio even during early withdrawals.

when ready annuities versus deferred annuities and taxes

An when ready annuity begins paying you right away, usually within a month of purchase. You move directly into the payout phase, so tax rules on each payment explore from the start. With an after-tax when ready annuity, you use the exclusion ratio when ready. With a pre-tax when ready annuity, each payment is fully taxable.

A deferred annuity grows for years or decades before you start taking payments. During the growth period, earnings are tax-deferred. Once you begin withdrawals or annuitize (convert to a payment stream), the same tax rules explore — exclusion ratio for after-tax, full taxation for pre-tax.

State income tax on annuity payments

Most states tax annuity income the same way the federal government does. If the payment is taxable at the federal level, it is usually taxable at the state level as well. A few states — including Illinois, Mississippi, Pennsylvania, and Tennessee — exempt certain types of retirement income, including annuity payments, but the rules vary by state and by the source of the annuity funding.

Check your state's tax authority website or speak with a tax professional if you live in a state with special retirement income rules. The insurance company issuing the annuity will not withhold state tax automatically unless you request it, so you may need to make estimated tax payments or adjust your withholding.

How to report annuity income on your tax return

The insurance company sends you a Form 1099-R for each year you receive annuity payments. This form shows the total amount paid, how much is taxable, and whether any federal tax was withheld. You report the taxable amount on your Form 1040 as income.

If you have an after-tax annuity and are using the exclusion ratio, you calculate the taxable portion yourself and report only that amount. Keep records of your original investment and the exclusion ratio calculation in case the IRS asks questions. If the insurance company made an error on the 1099-R, contact them to request a corrected form.

You can request that the insurance company withhold federal income tax from your annuity payments, which reduces the amount you receive but also reduces the tax bill when you file. This is optional but can help if you expect to owe a large amount.

Frequently Asked Questions

Do I have to pay taxes on annuity payments if I am retired?

Yes. Retirement status does not change whether annuity income is taxable. The tax depends on how the annuity was funded and whether it is pre-tax or after-tax money. You report the taxable portion as income on your tax return, just as you would if you were still working.

What is the difference between ordinary income tax and capital gains tax on annuities?

Annuity earnings are taxed as ordinary income, not as capital gains, even if you held the annuity for many years. This means they are taxed at your regular income tax rate, which is usually higher than the long-term capital gains rate. This is one reason annuities are less tax-efficient than some other investments.

Can I avoid taxes by not taking annuity payments?

If you do not take payments, you do not owe tax on the earnings that year. However, if you have a traditional IRA or 401(k) annuity, you must begin taking required minimum distributions at age 73. If you do not take the required amount, you owe a penalty. After-tax annuities have no RMD requirement.

What if I inherited an annuity from someone else?

Inherited annuities have special tax rules that depend on your relationship to the person who died and the type of annuity. Generally, you owe tax on payments you receive, but the tax treatment of the original contribution may differ. Consult a tax professional, as inherited annuity rules are complex and vary by situation.

Does the 10 percent early withdrawal penalty explore to all annuities?

The 10 percent penalty applies only to annuities funded with pre-tax retirement money (traditional IRA, 401(k), etc.) and only if you withdraw before age 59½. After-tax annuities do not have an early withdrawal penalty — you can withdraw your contribution anytime without penalty, though earnings may be taxable. Some exceptions to the penalty exist, such as substantially equal periodic payments or disability.