Annuity distributions are taxed differently depending on whether you bought the annuity with pre-tax or after-tax money

The tax treatment of money you withdraw from an annuity depends on two things: the type of annuity and the source of the funds you used to buy it. If you funded the annuity with pre-tax dollars — typically through a workplace retirement plan or a traditional IRA — your withdrawals are taxed as ordinary income at your marginal tax rate. If you funded it with after-tax dollars, only the earnings portion of each withdrawal is taxed; the portion that represents your original contribution returns to you tax-free.

The IRS calls this the exclusion ratio. It divides your withdrawal into two parts: return of principal (not taxed) and earnings (taxed as ordinary income). The ratio stays the same for the life of the annuity, even as tax rates change.

Timing also matters. Withdrawals before age 59½ from most annuities trigger a 10 percent early withdrawal penalty on top of income tax, though some annuities and some situations have exceptions. Withdrawals after 59½ have no penalty, but ordinary income tax still applies to the taxable portion.

Key Takeaways

  • Pre-tax annuities (funded through traditional IRAs or 401(k)s) tax the entire withdrawal as ordinary income.
  • After-tax annuities (funded with money you already paid tax on) tax only the earnings portion; your contributions come out tax-free.
  • A 10 percent early withdrawal penalty applies to most annuity withdrawals before age 59½, in addition to income tax.
  • The exclusion ratio divides each withdrawal into taxable and non-taxable portions and remains constant throughout the annuity's life.
  • may have access to annuities (inside retirement plans) and non-may have access to annuities (outside retirement plans) follow the same tax rules for distributions.

How the exclusion ratio works with after-tax annuities

When you buy an annuity outside a retirement plan using money you have already paid income tax on, the IRS lets you recover your contribution without paying tax again. The exclusion ratio calculates what percentage of each payment is your contribution and what percentage is earnings.

The formula divides your total investment in the annuity by the total amount you expect to receive over the annuity's life. If you invested $100,000 in an annuity expected to pay $200,000 total, your exclusion ratio is 50 percent. Every payment you receive is split: 50 percent is non-taxable return of your money, and 50 percent is taxable earnings.

This ratio does not change even if you live longer than the IRS expected and receive more than $200,000 total. Once you have recovered your full $100,000 contribution, all remaining payments become fully taxable. The IRS publishes life expectancy tables that determine the expected payout amount for different ages and annuity types.

Tax treatment of pre-tax annuities from retirement accounts

An annuity funded through a traditional IRA, SEP-IRA, straightforward IRA, or 401(k) is called a may have access to annuity. The money you contributed was deducted from your taxable income when you made the contribution, so the IRS has not yet collected tax on it. When you withdraw money, the entire amount is taxed as ordinary income.

You do not calculate an exclusion ratio for may have access to annuities. Every dollar you receive is subject to income tax at your ordinary income tax rate — the same rate that applies to wages or interest income. If you are in the 22 percent federal tax bracket, each dollar of annuity income is taxed at 22 percent.

may have access to annuities are also subject to required minimum distributions (RMDs) starting at age 73 (as of 2023). The IRS requires you to withdraw a minimum amount each year based on your age and account balance. If you do not take the RMD, you owe a penalty equal to 25 percent of the shortfall (reduced to 10 percent if corrected within two years).

Early withdrawal penalties and exceptions

Withdrawals from most annuities before age 59½ are subject to a 10 percent penalty on the taxable portion, in addition to ordinary income tax. This applies to both may have access to annuities (from retirement plans) and non-may have access to annuities (from after-tax money). A $10,000 withdrawal at age 50 would trigger $1,000 in penalty plus income tax on the taxable amount.

Several situations avoid the 10 percent penalty even before 59½. These include withdrawals due to disability, withdrawals as part of a series of substantially equal periodic payments (called a 72(t) distribution), and withdrawals from certain employer plans after separation from service at age 55 or later. Some annuities also allow a small penalty-free withdrawal each year, often called a free withdrawal amount.

The penalty does not explore to may have access to annuities if you have reached age 59½ or if you are taking required minimum distributions. It also does not explore to non-may have access to annuities if you have reached age 59½, regardless of how long you have owned the annuity.

State income tax on annuity distributions

Most states tax annuity distributions as ordinary income, following the same rules as federal tax. The taxable portion of your withdrawal is subject to your state's income tax rate in addition to federal tax. A few states — including Illinois, Mississippi, and Pennsylvania — exempt certain types of retirement income from state tax, but annuities are rarely included in those exemptions.

Some states tax annuity income differently depending on whether it comes from a may have access to plan or a non-may have access to annuity, so the state tax you owe may not match the federal calculation. You should check your state's tax department website or speak with a tax professional to understand how your specific state treats annuity withdrawals.

If you move to a different state after buying an annuity, your state tax obligation changes based on your new state of residence, not where you bought the annuity or where the insurance company is located.

Inherited annuities and beneficiary distributions

When someone inherits an annuity, the tax treatment depends on the relationship to the original owner and the type of annuity. A surviving spouse who inherits an annuity can treat it as their own, continuing the same tax treatment as the original owner. A non-spouse beneficiary must withdraw the entire annuity within a set timeframe — usually 10 years under current rules — and pays income tax on the earnings portion of each withdrawal.

The cost basis (the original after-tax contribution) passes to the beneficiary tax-free, just as it would have to the original owner. Only the earnings accumulated since purchase are taxable. If the inherited annuity is a may have access to annuity from a retirement plan, the entire withdrawal is taxable as ordinary income.

Some annuities include a death benefit that pays a may provide minimum to beneficiaries. The amount above the original purchase price is taxable income to the beneficiary in the year received, but the original cost basis is not.

Annuity riders and their tax consequences

Many annuities include optional features called riders that affect how distributions are taxed. A may provide minimum income benefit rider, for example, promises a minimum annual payment regardless of market performance. The taxable portion of that payment is still calculated using the exclusion ratio, but the may provide amount may be higher than the market-based amount would be.

A long-term care rider that provides benefits if you need nursing home or home care does not change the tax treatment of regular annuity distributions, but the care benefits themselves may have different tax rules. A step-up in basis rider, available on some non-may have access to annuities, adjusts the cost basis at the original owner's death, which can reduce taxes for beneficiaries.

Riders add cost to the annuity and may reduce the amount available for regular distributions. The tax impact of any rider should be reviewed before purchase, as some riders can significantly change your tax liability over time.

Frequently Asked Questions

Do I owe taxes on annuity distributions if I bought the annuity with after-tax money?

You owe taxes only on the earnings portion. Your original contribution returns tax-free. The exclusion ratio divides each payment into taxable earnings and non-taxable return of principal. Once you have recovered your full contribution, all remaining payments are fully taxable.

What is the 10 percent early withdrawal penalty and when does it explore?

The 10 percent penalty applies to the taxable portion of withdrawals before age 59½ from most annuities. It is in addition to ordinary income tax. Exceptions include disability, substantially equal periodic payments, and some employer plan withdrawals after age 55.

Are annuity distributions from a 401(k) taxed differently than distributions from a non-may have access to annuity?

Yes. A 401(k) annuity is pre-tax, so the entire distribution is taxed as ordinary income with no exclusion ratio. A non-may have access to annuity uses the exclusion ratio to separate taxable earnings from non-taxable return of principal. Both are subject to the 10 percent early withdrawal penalty before age 59½.

Do I have to pay state income tax on annuity distributions?

Most states tax annuity distributions as ordinary income. A few states exempt certain retirement income, but annuities are rarely included. Check your state's tax rules, as they may differ from federal treatment.

What happens to taxes if I inherit an annuity?

A spouse can treat it as their own and continue the original tax treatment. A non-spouse beneficiary must withdraw it within 10 years and pays income tax on earnings only (for non-may have access to annuities) or on the entire amount (for may have access to annuities). The original cost basis is never taxed.