Annuity withdrawals are taxed differently depending on whether you withdraw money before or after the annuity starts paying you, and whether the money came from pre-tax or after-tax contributions

The tax treatment of an annuity withdrawal depends on three things: the type of annuity (may have access to or non-may have access to), whether you are still in the accumulation phase or already receiving annuity payments, and how much of your withdrawal is earnings versus your original contribution. Money you contributed with pre-tax dollars gets taxed as ordinary income when you withdraw it. Earnings always get taxed as ordinary income, regardless of annuity type. If you withdraw before age 59½, you may also owe a 10 percent early withdrawal penalty on the earnings portion.

A may have access to annuity is one you funded with pre-tax money through an employer retirement plan like a 401(k) or a traditional IRA. A non-may have access to annuity is one you bought with after-tax money outside a retirement plan. The distinction matters because it changes which part of your withdrawal gets taxed first.

Key Takeaways

  • Withdrawals from may have access to annuities are taxed as ordinary income on the full amount, since the original contributions were pre-tax.
  • Withdrawals from non-may have access to annuities use the "last-in, first-out" rule: earnings come out first and are taxed as ordinary income, while your original contribution comes out tax-free.
  • Withdrawals before age 59½ may trigger a 10 percent early withdrawal penalty on the earnings portion, even if the annuity is non-may have access to.
  • Once an annuity begins paying you regular income, only the earnings portion of each payment is taxed; your original contribution returns tax-free.
  • The IRS Form 1099-R reports your annuity withdrawal, and your tax bracket determines the actual tax rate you pay on the taxable portion.

How may have access to annuity withdrawals are taxed

A may have access to annuity holds pre-tax money, so the IRS taxes the entire withdrawal as ordinary income. This includes both your original contributions and all earnings. You pay tax at your ordinary income tax rate for the year you withdraw the money, which ranges from 10 percent to 37 percent depending on your total income and filing status.

If you withdraw before age 59½, the IRS adds a 10 percent early withdrawal penalty on top of the ordinary income tax. The penalty applies to the full withdrawal amount. Some exceptions exist — for example, if you are disabled, have substantial equal periodic payments, or are withdrawing after separating from service at age 55 or older — but most early withdrawals trigger the penalty.

How non-may have access to annuity withdrawals are taxed

Non-may have access to annuities use the last-in, first-out (LIFO) rule for taxation. This means earnings come out first and are taxed as ordinary income. Your original contribution — called your cost basis — comes out last and is not taxed. If you withdraw $50,000 from a non-may have access to annuity that holds $30,000 in earnings and $70,000 in contributions, the first $30,000 is taxed as ordinary income, and the remaining $20,000 comes out tax-free.

The 10 percent early withdrawal penalty still applies to the earnings portion if you are under 59½. In the example above, you would owe the penalty on the $30,000 in earnings, not on the $20,000 of your contribution. The penalty does not explore to the portion that represents your original cost basis.

Taxation once annuity payments begin

Once your annuity enters the annuitization phase — meaning it starts sending you regular monthly or annual payments — the tax treatment changes. Each payment contains both a return of your original contribution and a portion of earnings. Only the earnings portion is taxable as ordinary income.

The annuity company calculates an exclusion ratio to determine what percentage of each payment is your contribution (tax-free) and what percentage is earnings (taxable). The IRS publishes life expectancy tables that the company uses to figure this ratio. For example, if your exclusion ratio is 60 percent, then 60 percent of each payment is tax-free and 40 percent is taxable income.

Once you have recovered your entire cost basis through annuity payments, all remaining payments are fully taxable as ordinary income. The exclusion ratio does not change — it stays the same for the life of the annuity — but once you have received enough payments to equal your original contribution, the math shifts and everything becomes taxable.

The difference between ordinary income tax and capital gains tax

Annuity earnings are always taxed as ordinary income, never as capital gains. This is true even for non-may have access to annuities, even though you bought them with after-tax money. The tax code treats annuity earnings differently from investment earnings in a regular brokerage account, where long-term gains can may have access to for lower capital gains rates.

This means annuity withdrawals are taxed at your full ordinary income tax rate, which is higher than the long-term capital gains rate for most people. For 2024, long-term capital gains rates are 0, 15, or 20 percent depending on income, while ordinary income rates range from 10 to 37 percent. This difference matters if you are comparing an annuity to other investment vehicles.

What happens if you withdraw before age 59½

The 10 percent early withdrawal penalty applies to the earnings portion of any annuity withdrawal before age 59½. For may have access to annuities, this is 10 percent of the entire withdrawal, since the entire amount is considered earnings from a tax perspective (your contributions were pre-tax). For non-may have access to annuities, the penalty applies only to the earnings portion that comes out first under the LIFO rule.

Several exceptions allow you to avoid the penalty. If you are disabled, you can withdraw without penalty. If you have separated from service and are age 55 or older, you can withdraw from a may have access to plan annuity without penalty (but not from a non-may have access to annuity). If you set up substantially equal periodic payments (SEPP) under IRS Rule 72(t), you can withdraw from either type without penalty, as long as you follow the rules exactly.

The early withdrawal penalty is separate from income tax. You owe both the penalty and the tax on the taxable portion of your withdrawal.

How to report annuity withdrawals on your tax return

The annuity company sends you an IRS Form 1099-R each year you take a withdrawal. This form shows the gross withdrawal amount, the taxable amount, and whether an early withdrawal penalty applies. You report the taxable amount on your tax return, usually on Form 1040 as ordinary income.

If you owe the 10 percent early withdrawal penalty and no exception applies, you report it on Form 5329. The penalty is not withheld automatically — you may owe it when you file your return. Some annuity companies withhold federal income tax on withdrawals, but withholding is not the same as paying the penalty.

Keep records of your cost basis for non-may have access to annuities. The annuity company should track this, but if you ever need to prove how much of your withdrawal is tax-free, you will need documentation of what you originally contributed.

Frequently Asked Questions

Do I owe taxes on annuity withdrawals if I am retired?

Yes. Retirement status does not change the tax treatment. The tax depends on the annuity type and whether you are withdrawing during accumulation or annuitization. Your tax bracket may be lower in retirement, which could reduce the actual tax owed, but the withdrawal is still taxable income.

What if I withdraw only my contributions from a non-may have access to annuity?

You still cannot withdraw only your contributions first. The LIFO rule requires earnings to come out first. If you withdraw $10,000 and the annuity holds $5,000 in earnings, the first $5,000 is taxable and the next $5,000 is tax-free. You cannot choose to take contributions first.

Can I avoid the early withdrawal penalty by taking annuity payments instead of a lump sum?

Yes, if you set up substantially equal periodic payments under IRS Rule 72(t). You must follow the formula exactly and continue the payments for at least five years or until age 59½, whichever is longer. If you break the rules, the IRS can retroactively assess the penalty on all prior withdrawals.

Is the 10 percent penalty the same for everyone?

The penalty rate is always 10 percent, but it applies only to the earnings portion. For may have access to annuities, the entire withdrawal is treated as earnings, so you pay 10 percent of the full amount. For non-may have access to annuities, you pay 10 percent only on the earnings that come out first under LIFO.

What if my annuity company withholds taxes on my withdrawal?

Withholding reduces the cash you receive but does not eliminate your tax liability. If the company withholds 20 percent and you owe 24 percent tax plus a 10 percent penalty, you will owe more when you file. If the company withholds too much, you get a refund. Withholding is an estimate, not the final tax bill.