Annuities are not tax-free, but the tax you owe depends on when you bought it and what money you used to buy it

An annuity itself is not a tax-free investment. You will owe income tax on the earnings your annuity generates, though the timing and amount depend on two things: whether you funded it with pre-tax or after-tax dollars, and whether you bought it inside a retirement account like an IRA or outside one.

The confusion often comes from the fact that annuities grow tax-deferred — meaning you do not pay tax on the earnings each year while the money sits in the contract. But tax-deferred is not the same as tax-free. When you start taking money out, you will owe federal income tax on the portion that represents earnings, and possibly state income tax as well.

Key Takeaways

  • Money you earn inside an annuity contract is not taxed each year, but you pay income tax on those earnings when you withdraw them.
  • If you funded the annuity with after-tax money (money you already paid income tax on), you only pay tax again on the earnings portion, not the original amount you put in.
  • If you funded the annuity with pre-tax money inside an IRA or 401(k), every dollar you withdraw is taxed as ordinary income.
  • Withdrawals before age 59½ from non-IRA annuities usually trigger a 10 percent penalty on top of income tax, though some exceptions exist.
  • The tax you owe each year depends on how much you withdraw and your total income that year, not on a fixed percentage of the annuity.

Tax-deferred growth versus tax-free growth

Tax-deferred means the annuity does not send you a tax bill each year for the interest, dividends, or gains it earns. That money stays inside the contract and compounds without annual tax drag. This is different from a regular savings account or taxable brokerage account, where you owe tax on earnings every year whether you withdraw them or not.

Tax-free means you never owe tax on the money, even when you withdraw it. Roth IRAs and Roth 401(k)s offer tax-free growth and withdrawals, but annuities do not. An annuity is tax-deferred only — the tax bill is postponed, not erased.

How annuities funded with after-tax money are taxed

If you bought an annuity outside a retirement account using money you already paid income tax on, the IRS uses the exclusion ratio to determine what portion of each withdrawal is taxable. The exclusion ratio divides your original investment (called the cost basis) by the total amount you expect to receive over the life of the annuity.

Example: You invest $100,000 in an when ready annuity that will pay you $500 per month for life. If the insurance company calculates you will receive $180,000 total over your life expectancy, your exclusion ratio is $100,000 ÷ $180,000, or about 56 percent. That means 56 percent of each $500 payment is a return of your own money (not taxed), and 44 percent is earnings (taxed as ordinary income).

Once your withdrawals total your original investment, the exclusion ratio stops explore. After that point, every dollar you withdraw is taxed as ordinary income, because it is all earnings.

How annuities funded with pre-tax money are taxed

If you bought the annuity inside an IRA, SEP-IRA, or 401(k) using pre-tax contributions, the entire amount you withdraw is taxed as ordinary income. There is no exclusion ratio because the IRS already gave you a tax deduction when you contributed the money. The tax bill was always going to come due; the annuity just postponed it.

This applies whether the annuity earned $10,000 or $100,000 in gains. The tax treatment does not change based on performance — only on the source of the money used to buy it.

The 10 percent early withdrawal penalty

If you withdraw money from a non-IRA annuity before age 59½, you typically owe a 10 percent penalty on top of ordinary income tax. This penalty applies to the earnings portion only, not to your original investment.

Some annuities include a free withdrawal provision that lets you take out a small percentage each year (often 10 percent) without penalty. Others charge a surrender charge if you withdraw more than that amount within a set period, usually 5 to 10 years. The surrender charge is separate from the IRS penalty and goes to the insurance company, not the government.

Exceptions to the 10 percent penalty exist for certain hardships, such as disability or substantial equal periodic payments, but these are narrow and require documentation. The IRA rules are different — withdrawals from an IRA annuity before 59½ also face the 10 percent penalty, but with different exceptions.

State income tax on annuities

Most states tax annuity withdrawals as ordinary income, just as the federal government does. A few states do not tax retirement income at all, including Florida, Texas, and Wyoming. Others tax only certain types of retirement income or offer partial exemptions for people over a certain age.

The state tax you owe depends on where you live when you withdraw the money, not where you bought the annuity. If you move to a state with no income tax after buying an annuity in a state with income tax, you will owe tax to your new state based on its rules.

Annuities inside Roth accounts

You can buy an annuity inside a Roth IRA or Roth 401(k), and in that case the withdrawals are tax-free — but only if you follow the Roth rules. For a Roth IRA, you must be at least 59½ and have held the account for at least five years. For a Roth 401(k), your employer's plan rules explore, but the five-year rule still holds.

This is the only way to own an annuity that produces truly tax-free withdrawals. The annuity itself is still tax-deferred while the money sits in the contract, but the Roth wrapper makes the final withdrawal tax-free.

Frequently Asked Questions

Do I owe tax on annuity withdrawals if I do not withdraw anything?

No. You owe tax only when you withdraw money. The earnings inside the contract are not taxed each year. However, if you own an annuity inside a non-Roth IRA or 401(k), you must start taking required minimum distributions at age 73 (as of 2023), and those withdrawals are taxed.

What if I withdraw only the money I put in, not the earnings?

If the annuity was funded with after-tax money, withdrawals of your original investment are not taxed (up to the amount of your cost basis). Once you have withdrawn your full investment, further withdrawals are all taxed as earnings. If the annuity is inside a pre-tax retirement account, all withdrawals are taxed regardless of whether they represent your contribution or earnings.

Can I avoid the tax by transferring my annuity to someone else?

No. Transferring or gifting an annuity does not erase the tax obligation. The new owner will owe tax on the earnings when they withdraw money. Some annuities allow tax-free transfers between spouses in a divorce, but this is a narrow exception and requires specific language in the divorce decree.

Are annuity payments taxed differently than a lump sum withdrawal?

No. Whether you take the money as monthly payments or a lump sum, the tax treatment is the same. The exclusion ratio (for after-tax annuities) or full taxation (for pre-tax annuities) applies either way. The only difference is the timing of when you owe the tax.