Most annuity income is taxed as ordinary income, but the tax treatment depends on whether you contributed pre-tax or after-tax dollars

When you receive payments from an annuity, the IRS taxes the earnings portion as ordinary income at your regular tax rate — the same rate applied to wages or interest. The part of each payment that represents your original contribution (called your cost basis) is not taxed again, since you already paid taxes on that money or set it aside after-tax.

How much of each payment gets taxed depends on the type of annuity you own. If you bought the annuity with pre-tax money (like funds from a traditional IRA or 401(k)), nearly all of your payments are taxed as ordinary income. If you bought it with after-tax money, only the earnings portion is taxed, and you recover your cost basis tax-free.

The IRS uses a formula called the exclusion ratio to determine what portion of each payment is taxable. This ratio stays the same throughout your payout period, even if interest rates or market conditions change.

Key Takeaways

  • Annuity earnings are always taxed as ordinary income, not at the lower capital gains rate.
  • Your original contribution (cost basis) is recovered tax-free if the annuity was purchased with after-tax dollars.
  • The exclusion ratio divides your cost basis by your expected total payments to determine what portion of each check is taxable.
  • Withdrawals before age 59½ from may have access to annuities may trigger a 10% early withdrawal penalty in addition to ordinary income tax.
  • Annuities held inside IRAs or 401(k)s defer taxes until withdrawal, but the entire payout is then taxed as ordinary income.

How the exclusion ratio works

The exclusion ratio is the IRS method for separating your cost basis from earnings in each annuity payment. To calculate it, divide your total cost basis (what you paid into the annuity) by your expected return (the total amount you will receive over your lifetime, based on IRS life expectancy tables).

For example, if you paid $100,000 into an annuity and the IRS life expectancy tables show you will receive $200,000 total, your exclusion ratio is 50 percent ($100,000 ÷ $200,000). If your monthly payment is $1,000, then $500 is your cost basis (not taxed) and $500 is earnings (taxed as ordinary income).

Once calculated, this ratio does not change, even if you live longer than the IRS tables predicted or if the annuity's underlying investments perform better than expected. The same percentage applies to every payment you receive for the rest of your life.

may have access to annuities versus non-may have access to annuities

A may have access to annuity is purchased with pre-tax money from a retirement account like a traditional IRA, SEP-IRA, or 401(k). Because you never paid income tax on the money going in, the entire payout is taxed as ordinary income. There is no cost basis to recover tax-free.

A non-may have access to annuity is purchased with after-tax money — money you already paid income tax on or money you set aside from your personal savings. With a non-may have access to annuity, you recover your cost basis tax-free and pay ordinary income tax only on the earnings portion.

This distinction matters significantly over time. A $100,000 non-may have access to annuity might generate $50,000 in taxable earnings over your lifetime, while a $100,000 may have access to annuity generates $50,000 in taxable earnings but all of it is taxed because none of it is cost basis.

The 10% early withdrawal penalty

If you withdraw money from a may have access to annuity (one held in an IRA or 401(k)) before age 59½, the IRS imposes a 10% early withdrawal penalty on top of ordinary income tax. This penalty applies to the earnings portion of the withdrawal.

Non-may have access to annuities have different rules. The earnings are subject to ordinary income tax and the 10% penalty if withdrawn before 59½, but your cost basis can be withdrawn without penalty at any time. Many insurance companies also impose their own surrender charges if you withdraw before a set period (often 5 to 10 years), regardless of your age.

Some exceptions exist to the 10% penalty — for instance, if you are disabled, have substantial medical expenses, or take payments in a series of substantially equal periodic payments (called a 72(t) distribution). The rules are complex, so check with a tax professional before withdrawing early.

Annuities inside retirement accounts versus outside

An annuity held inside a traditional IRA or 401(k) is a may have access to annuity. Taxes are deferred while the annuity is growing, and the entire payout is taxed as ordinary income when you receive it. You must begin taking required minimum distributions (RMDs) at age 73 (as of 2023), and those distributions are fully taxable.

An annuity held outside a retirement account is a non-may have access to annuity. Taxes on the earnings are deferred while the annuity is growing, but you report the earnings on your tax return each year once payouts begin. You do not have RMD requirements, and you can withdraw your cost basis at any time without penalty.

The tax deferral inside a retirement account can be valuable if you expect to be in a lower tax bracket in retirement. However, the entire payout is taxed as ordinary income, not at capital gains rates, so the benefit depends on your specific situation.

Lump-sum payouts and tax withholding

If you take a lump-sum distribution from an annuity instead of receiving monthly payments, the entire earnings portion is taxed in that single year as ordinary income. This can push you into a higher tax bracket for that year.

Annuity providers are required to withhold federal income tax from your payments. For may have access to annuities, they typically withhold 20% of the distribution. For non-may have access to annuities, they withhold based on your W-4 form or a separate withholding election. If too little is withheld, you will owe the difference when you file your tax return.

You can adjust withholding by filing a new W-4 form with the annuity provider or by making estimated tax payments throughout the year if you expect a large tax bill.

State income tax on annuities

Most states tax annuity income as ordinary income, explore the same state income tax rate to the taxable portion of your payments. A few states — including Illinois, Mississippi, and Pennsylvania — offer partial or full exemptions for retirement income, including annuity payouts, though the rules vary widely.

If you move to a different state after you begin receiving annuity payments, you may owe taxes to your new state on the income. Some states have reciprocal agreements or allow credits for taxes paid to another state, but this is not may provide. Check your state's tax rules before relocating.

Frequently Asked Questions

Are annuity payouts taxed differently than regular income?

Annuity earnings are taxed as ordinary income at your regular tax rate, not at capital gains rates. The cost basis portion of each payment is not taxed. So if half your payment is cost basis and half is earnings, you pay ordinary income tax on the earnings half only.

Do I have to pay taxes on annuity payments if I bought it with my own money?

You pay taxes only on the earnings portion. Your original contribution (cost basis) is recovered tax-free. The exclusion ratio determines what percentage of each payment is earnings versus cost basis. Over time, as you recover your full cost basis, a larger portion of each payment becomes taxable.

What happens if I withdraw money from my annuity before age 59½?

For may have access to annuities (held in IRAs or 401(k)s), the earnings portion is subject to a 10% early withdrawal penalty plus ordinary income tax. For non-may have access to annuities, your cost basis can be withdrawn without penalty, but earnings face the 10% penalty. Insurance companies may also charge surrender fees.

Do I report annuity income on my tax return every year?

For non-may have access to annuities, yes — you report the taxable earnings portion each year. For may have access to annuities held in IRAs or 401(k)s, taxes are deferred until you withdraw, then the entire withdrawal is taxed. Once you begin receiving payments from either type, you report the taxable portion annually.

Can I avoid taxes on annuity payouts?

No, but you can defer them by keeping the annuity in a may have access to retirement account. You can also minimize taxes by purchasing a non-may have access to annuity with after-tax money, which lets you recover your cost basis tax-free. A tax professional can help you structure withdrawals to manage your tax bracket.