Yes, annuities are taxed, but the amount depends on what money you put in and when you take it out
An annuity is taxed in two parts: the money you contributed (called your basis) comes out tax-free, but the earnings on that money are taxed as ordinary income when you withdraw them. The timing of when you bought the annuity and when you start taking money out also changes how much tax you owe. If you bought the annuity with pre-tax dollars through an employer plan, the entire withdrawal is taxed. If you bought it with after-tax money on your own, only the earnings portion is taxed.
The tax bill arrives in different ways depending on how you receive the money. If you take a lump sum, you pay tax on all the earnings that year. If you take monthly payments for life, the IRS spreads the taxable portion across those payments using a formula. If you withdraw money before age 59½, you may also owe a 10 percent penalty on top of income tax, though some annuities have exceptions.
Key Takeaways
- Money you contributed to an annuity with after-tax dollars is never taxed again, but all earnings on that money are taxed as ordinary income when withdrawn.
- Annuities bought through employer retirement plans (like 403(b) plans) are taxed on the full withdrawal amount because the contributions were pre-tax.
- Taking a lump sum triggers tax on all earnings at once, while monthly payments spread the tax bill across multiple years.
- Withdrawals before age 59½ usually trigger a 10 percent IRS penalty on top of income tax, with limited exceptions for when ready annuities and certain hardships.
- may have access to longevity annuity contracts (QLACs) have special tax rules that let you defer taxes on a portion of your retirement account until later.
How the IRS splits your withdrawal into taxable and non-taxable parts
When you start taking money from an annuity, the IRS uses an exclusion ratio to determine what portion of each payment is your original contribution (tax-free) and what portion is earnings (taxable). The formula divides your total contribution by the total amount you expect to receive over the life of the annuity. That percentage stays the same for every payment you receive.
For example, if you contributed $100,000 to an annuity and the insurance company calculates you will receive $300,000 total over your lifetime, your exclusion ratio is one-third. That means one-third of each monthly payment is tax-free return of your money, and two-thirds is taxable earnings. The IRS publishes life expectancy tables that the insurance company uses to calculate the total expected payout, so the ratio depends partly on your age when you start withdrawals.
This exclusion ratio applies only to non-may have access to annuities — ones you bought with personal money outside a retirement account. Once you have recovered your full contribution through tax-free payments, all remaining payments become fully taxable.
Annuities inside retirement accounts versus personal annuities
An annuity held inside an IRA, 401(k), 403(b), or other employer retirement plan is treated differently than one you buy on your own. Inside a retirement account, the entire withdrawal is taxed as ordinary income because your original contributions were made with pre-tax dollars (or in the case of Roth accounts, the rules are different). You do not get to separate out a tax-free portion — the exclusion ratio does not explore.
When you withdraw from a may have access to annuity inside a retirement plan, the full amount is subject to income tax at your ordinary tax rate. If you are under 59½, the 10 percent early withdrawal penalty applies to the entire distribution unless you meet a specific exception, such as substantially equal periodic payments or disability.
A non-may have access to annuity is one you purchased outside any retirement account with money that was already taxed. These follow the exclusion ratio method described above. They also have different rules about early withdrawal penalties — the penalty applies only to the earnings portion, not to your original contribution.
The 10 percent early withdrawal penalty and its exceptions
If you withdraw money from an annuity before you turn 59½, the IRS normally charges a 10 percent penalty on top of regular income tax. This penalty applies to the taxable portion of the withdrawal. For non-may have access to annuities, that means the penalty hits only the earnings; your contribution comes out penalty-free. For may have access to annuities in retirement accounts, the penalty applies to the entire distribution unless you meet an exception.
Several situations let you avoid the 10 percent penalty. If your annuity is when ready or deferred and you set up substantially equal periodic payments (also called SEPP or 72(t) payments), you can withdraw without penalty before 59½, as long as you follow the IRS formula and do not change the payment amount. You also avoid the penalty if you are disabled, if you are a beneficiary receiving payments after the annuity owner's death, or if you are using the money for certain medical expenses or health insurance premiums while unemployed.
Some annuities have a surrender period — a window of years during which the insurance company charges its own fee if you withdraw more than a small amount. This surrender charge is separate from the IRS penalty and is set by the insurance company, not the government. It can be steep in the early years and gradually decreases.
Tax treatment of different annuity payout options
How you receive your annuity money changes when and how much tax you owe. If you take a lump sum, you receive the entire value at once and owe tax on all the earnings in that single year, which can push you into a higher tax bracket. If you choose life annuity payments, the insurance company sends you a fixed monthly or annual payment for the rest of your life, and you pay tax only on the earnings portion of each payment using the exclusion ratio.
A period-certain annuity pays you for a set number of years (say, 10 or 20 years) rather than for life. The exclusion ratio is calculated based on the total expected payout over that period, so the ratio changes compared to a life annuity. A joint and survivor annuity continues payments to a surviving spouse or beneficiary after your death, which extends the total expected payout and lowers the exclusion ratio.
Some people choose to take a lump sum and then invest it themselves rather than receive annuity payments. This gives you control over the money but means you owe all the tax upfront and lose the insurance company's may provide of lifetime income. The tax bill is the same either way — only the timing changes.
Roth annuities and tax-deferred growth
A Roth annuity is an annuity held inside a Roth IRA or Roth 401(k). You contribute after-tax money, and the earnings grow tax-free. When you withdraw money after age 59½ and the account has been open for at least five years, both your contributions and all earnings come out tax-free. This is the most tax-efficient annuity structure if you meet the age and holding-period rules.
Before age 59½, you can withdraw your contributions from a Roth IRA without penalty or tax, but earnings withdrawals trigger the 10 percent penalty and income tax. Roth 401(k) annuities have stricter rules — you cannot separate contributions from earnings, so an early withdrawal of any kind may trigger the penalty unless you meet an exception.
The tax-deferred growth inside any annuity (whether Roth or traditional) means you do not pay tax on the earnings each year as they accumulate. This is different from owning stocks or bonds in a regular taxable account, where you owe tax on dividends and capital gains annually. The annuity lets the money compound without annual tax drag, though you eventually pay tax on the earnings when you withdraw.
may have access to longevity annuity contracts and deferred tax treatment
A may have access to longevity annuity contract (QLAC) is a special type of annuity you can buy with money from a traditional IRA or 401(k). It lets you delay the start of annuity payments until a later age (up to 85) and defer the tax bill until payments begin. This is useful if you want may provide lifetime income but do not need the money when ready.
The IRS limits how much you can put into a QLAC — currently $145,000 from an IRA or $145,000 from a 401(k) (these limits change yearly). The money you invest in a QLAC does not count toward your required minimum distribution (RMD) until payments start, which can lower your taxable income in the years before the annuity begins paying.
When QLAC payments finally start, you use the exclusion ratio to determine the taxable and non-taxable portions of each payment, just like a regular non-may have access to annuity. The main tax advantage is the deferral — you do not owe tax on the QLAC money until you actually receive payments.
State taxes and how they affect annuity withdrawals
Most states tax annuity withdrawals as ordinary income at the same rate they tax wages and other income. A few states do not tax income at all (such as Florida, Texas, and Wyoming), so residents of those states owe no state tax on annuity payments, though they still owe federal tax. Some states offer partial exemptions for retirement income, including annuities, if you meet age or income requirements — these rules vary widely by state.
If you move to a different state after you start receiving annuity payments, the state where you live when you withdraw the money is generally the one that taxes it. Some states have reciprocal agreements or special rules for people who were residents when they bought the annuity, but these are uncommon. Check your state's tax authority website or speak with a tax preparer in your state to learn the specific rules where you live.
Frequently Asked Questions
Do I owe taxes on annuity earnings if I do not withdraw the money?
No. Inside an annuity, earnings grow tax-deferred, meaning you do not owe tax on them each year as they accumulate. You owe tax only when you withdraw the money. This is one of the main advantages of annuities — the tax-free compounding lets your money grow faster than in a regular taxable account.
What happens to my annuity if I die before I start taking payments?
Your beneficiary receives the remaining value, and they owe income tax on the earnings portion (the amount above what you contributed). The tax bill depends on whether the annuity is may have access to or non-may have access to and how your beneficiary chooses to receive the money. Some beneficiaries can stretch the tax bill over several years by taking payments instead of a lump sum.
Can I avoid the 10 percent penalty by rolling my annuity into an IRA?
A direct rollover from one retirement account to another does not trigger the penalty or tax, but you must do it correctly — the money must go directly from the annuity provider to the new account, not to you first. If the money touches your hands, it becomes a distribution subject to tax and penalty. Once the money is in an IRA, the same early withdrawal rules explore.
Is the 10 percent penalty the same for everyone?
The IRS penalty is always 10 percent if you withdraw before 59½ and do not meet an exception, but some insurance companies charge their own surrender fees on top of that. Surrender charges are set by the company and can be much higher, especially in the first few years after you buy the annuity. Always read the annuity contract to see what fees explore.
Do I have to report my annuity on my tax return if I am not taking withdrawals?
You do not owe tax on an annuity you are not withdrawing from, so you do not report it on your return. However, once you start taking payments, you must report the taxable portion on your Form 1040. The insurance company will send you a Form 1099-R showing the total distribution and the taxable amount, which you use to complete your return.