The tax treatment of an annuity depends on what money funded it and when you withdraw

Annuities are taxed differently depending on whether you bought them with pre-tax dollars (through a may have access to retirement plan like a 401(k) or traditional IRA) or after-tax dollars (from a Roth IRA or personal savings). Money you withdraw from a may have access to annuity is taxed as ordinary income in the year you receive it. Money from a non-may have access to annuity is taxed only on the earnings portion, not on the amount you originally invested — the IRS calls this the "exclusion ratio." If you withdraw money before age 59½ from either type, you may owe a 10 percent early withdrawal penalty on top of income tax, though some annuities and situations have exceptions.

Key Takeaways

  • may have access to annuities (funded with pre-tax retirement account money) tax the entire withdrawal as ordinary income, while non-may have access to annuities (funded with after-tax money) tax only the earnings portion.
  • The exclusion ratio determines what percentage of each non-may have access to annuity payment counts as taxable earnings versus tax-free return of your original investment.
  • Withdrawals before age 59½ from either type of annuity typically trigger a 10 percent early withdrawal penalty, plus ordinary income tax.
  • Annuities held inside IRAs or 401(k)s follow the tax rules of those accounts, not separate annuity tax rules.

How may have access to annuities are taxed

A may have access to annuity is one you funded with money that was never taxed — typically from a traditional IRA, 401(k), 403(b), or other employer retirement plan. Because you got a tax deduction when that money went in, the IRS taxes it when it comes out. Every dollar you withdraw is taxed as ordinary income at your marginal tax rate for that year.

If you bought the annuity inside a traditional IRA with a $50,000 rollover, and you start receiving $500 monthly payments, all $500 of each payment is taxable income. You report it on your tax return, and it counts toward your total income for the year — which can affect your tax bracket, your Medicare premiums, and whether you owe tax on Social Security benefits.

This tax treatment continues for the life of the annuity, whether you receive payments for five years or thirty years. The IRS does not distinguish between your original contribution and the earnings the annuity generated — it all comes out as taxable income.

How non-may have access to annuities are taxed

A non-may have access to annuity is one you bought with after-tax money — money you already paid income tax on, from a savings account, a brokerage account, or personal funds. Because you already paid tax on the principal, the IRS taxes only the earnings (interest and investment gains) when you withdraw them. Your original investment comes out tax-free.

The IRS uses the exclusion ratio to determine what portion of each payment is earnings and what portion is your return of investment. The formula is: your original investment divided by the total amount you expect to receive over the life of the annuity. If you invested $100,000 in an annuity that will pay you $200,000 total over its life, your exclusion ratio is 0.50 — meaning 50 percent of each payment is tax-free return of your investment, and 50 percent is taxable earnings.

The insurance company calculates this ratio using IRS life expectancy tables based on your age when payments begin. Once set, the ratio stays the same for the entire annuity period. If you live longer than the life expectancy table predicted, all payments beyond the breakeven point are fully taxable as earnings. If you die before receiving your full investment back, your beneficiary may claim the unrecovered investment as a loss on their tax return.

Early withdrawal penalties and exceptions

If you withdraw money from an annuity before age 59½, you typically owe a 10 percent penalty on top of ordinary income tax. This applies to both may have access to and non-may have access to annuities, though the penalty applies only to the taxable portion of the withdrawal.

Some withdrawals are exempt from the 10 percent penalty. These include withdrawals made as part of a substantially equal periodic payment (SEPP) plan, also called a 72(t) distribution — a series of equal payments calculated using IRS formulas that must continue for five years or until you reach 59½, whichever is longer. Other exceptions include withdrawals due to disability, medical expenses exceeding 7.5 percent of adjusted gross income, or payments to a beneficiary after the annuity owner's death.

Some annuities also allow a small annual withdrawal (often 10 percent of the account value) without penalty, though this is a feature of the specific contract, not an IRS rule. Check your annuity contract to see what withdrawals it permits penalty-free.

Annuities held inside retirement accounts

If you own an annuity inside a traditional IRA, Roth IRA, 401(k), or other may have access to retirement plan, the annuity itself does not have its own tax rules — it follows the tax rules of the account that holds it. A non-may have access to annuity inside a traditional IRA is taxed as if it were a may have access to annuity, because the IRA is the may have access to account. A non-may have access to annuity inside a Roth IRA grows tax-free and withdrawals are tax-free (subject to Roth withdrawal rules).

This matters because it means you cannot use the exclusion ratio to separate earnings from principal when an annuity is inside an IRA. The account type determines the tax treatment, not the annuity type. If you want the tax advantage of the exclusion ratio, the annuity must be held outside any retirement account.

Inherited annuities and tax consequences

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 may have access to annuity from a spouse, you can treat it as your own, and the tax rules above explore. If you inherit it as a non-spouse beneficiary, you must begin withdrawals according to IRS rules, and those withdrawals are taxed the same way they would have been for the original owner.

If you inherit a non-may have access to annuity, you receive a step-up in basis on the earnings portion as of the date of death, meaning you owe tax only on earnings that accumulate after you inherit it. This can significantly reduce your tax burden compared to what the original owner would have owed.

Annuity taxation and required minimum distributions

If you own an annuity inside a may have access to retirement account like a traditional IRA or 401(k), you must begin taking required minimum distributions (RMDs) at age 73 (as of 2023, under the find 2.0 Act). The amount is calculated based on your account balance and life expectancy, and the full distribution is taxed as ordinary income.

If you own a non-may have access to annuity outside a retirement account, there are no required minimum distributions — you can leave it untouched as long as you want. However, if the annuity is inside an IRA or 401(k), the RMD rules of that account explore regardless of the annuity's structure.

Frequently Asked Questions

Do I owe taxes on annuity growth before I start taking withdrawals?

No. Whether the annuity is may have access to or non-may have access to, the money grows tax-deferred inside the contract. You owe taxes only when you withdraw money. This tax deferral is one reason people buy annuities, though it comes with surrender charges and other contract restrictions.

What happens to my annuity if I die before I receive all my money back?

That depends on the annuity contract. Some annuities have a death benefit that pays your beneficiary the remaining balance or a may provide minimum. Others do not — if you chose a life-only payout option, payments stop when you die. Check your contract to see what it guarantees to your beneficiary.

Can I avoid the 10 percent early withdrawal penalty by using a SEPP plan?

Yes, but only if you follow the IRS rules exactly. You must take substantially equal periodic payments using one of three IRS-approved calculation methods, and the payments must continue for five years or until you reach 59½, whichever is longer. If you break the pattern, you owe the penalty retroactively plus interest.

Is the exclusion ratio the same for every non-may have access to annuity?

No. Each annuity has its own exclusion ratio based on how much you invested, your age when payments begin, and the total amount you are expected to receive. Two people with the same investment amount but different ages will have different exclusion ratios because life expectancy tables differ by age.

Do I report annuity income on my tax return myself, or does the insurance company handle it?

The insurance company sends you a Form 1099-R each year showing the total distribution and the taxable portion. You report this on your tax return. If the company makes an error on the form, you can still report the correct amount on your return, but you may need to file an amended return if the IRS questions the discrepancy.