You pay taxes on annuity earnings, but the timing and rate depend on whether the annuity is may have access to or non-may have access to

An annuity itself is not taxed when you buy it — you fund it with money you've already decided to spend. But when the annuity starts paying you, those payments contain earnings, and earnings are taxable income. The tax you owe depends on two things: whether the annuity is may have access to (funded with pre-tax retirement money like a 401(k) rollover) or non-may have access to (funded with after-tax money), and whether you're taking withdrawals before or after the annuity begins its payout phase.

The IRS treats may have access to and non-may have access to annuities differently because may have access to annuities already got a tax break when the money went in. With a may have access to annuity, you'll owe income tax on the full amount of each payment. With a non-may have access to annuity, you'll owe tax only on the earnings portion — the original money you put in comes out tax-free.

Key Takeaways

  • may have access to annuities (funded with pre-tax retirement money) are taxed on the full payment amount; non-may have access to annuities (funded with after-tax money) are taxed only on earnings.
  • During the accumulation phase, you owe no annual tax on earnings inside the annuity, but withdrawals before age 59½ may trigger a 10% penalty plus income tax.
  • Once the annuity begins paying you, each payment is partly return of principal (tax-free for non-may have access to) and partly earnings (always taxable).
  • The IRS uses an exclusion ratio to determine what portion of each payment is taxable on non-may have access to annuities.
  • You must report annuity income on your tax return; the insurance company will send you a 1099-R form showing what you received.

How may have access to and non-may have access to annuities are taxed differently

A may have access to annuity is funded with money that came from a retirement account — typically a 401(k), 403(b), IRA, or similar plan where contributions were made with pre-tax dollars. Because you got a tax deduction when that money went in, the IRS wants tax when it comes out. When you receive a payment from a may have access to annuity, the entire payment is ordinary income and you owe federal income tax on it at your regular tax rate.

A non-may have access to annuity is funded with money you already paid taxes on — savings, investment accounts, or other after-tax sources. The IRS has already collected tax on the principal, so it only taxes you on the new earnings the annuity generated. This means part of each payment is a return of your own money (tax-free) and part is earnings (taxable). The insurance company calculates this split using an exclusion ratio, which divides your original investment by the total amount you're expected to receive over the life of the annuity.

State income tax follows the same rules as federal tax in most states. A few states do not tax retirement income, including annuity payments, but you'll need to check your state's rules.

Taxes during the accumulation phase (before payments begin)

While your annuity is growing and you're not yet taking payments, you owe no annual tax on the earnings inside the account. This is one of the main reasons people buy annuities — the money compounds without being taxed each year the way it would in a regular investment account. You don't file anything or report anything during this phase; the tax is straightforward deferred.

However, if you withdraw money from the annuity before age 59½, the IRS imposes a 10% early withdrawal penalty on the earnings portion, in addition to ordinary income tax on those earnings. The principal (your original investment) comes out penalty-free, but the growth does not. Some annuities allow a small withdrawal each year without penalty — often called a free withdrawal provision — so check your contract.

Exceptions to the early withdrawal penalty exist for certain situations, such as disability, but they are narrow. If you think you might need the money before 59½, discuss this with the insurance agent or your tax professional before buying.

Taxes once the annuity starts paying you

Once the annuity enters the payout phase and begins sending you regular payments, each payment contains both a return of your principal and earnings. For a may have access to annuity, you owe tax on the full payment. For a non-may have access to annuity, you owe tax only on the earnings portion.

The insurance company calculates the exclusion ratio by dividing your investment in the contract (the amount you paid in) by the expected return (the total amount you're projected to receive). If you invested $100,000 and the annuity is expected to pay you $200,000 total, your exclusion ratio is 50%, meaning half of each payment is tax-free and half is taxable. This ratio stays the same for the life of the annuity, even if you live longer than expected and receive more than the projected total.

If the annuity is a joint annuity covering two people, the calculation changes slightly because the expected return is based on both lifespans. The insurance company will provide the exclusion ratio in writing when payments begin.

What happens if you live longer than the annuity's life expectancy

If you outlive the annuity's projected payout period, the tax treatment changes. Once you've recovered your entire original investment through tax-free returns of principal, all remaining payments become fully taxable — even on a non-may have access to annuity. This is called the recovery of basis.

The insurance company tracks this for you and will notify you when you've recovered your full investment. From that point forward, every dollar you receive is treated as earnings and is fully taxable. This is another reason to keep your annuity statements: you need to know when you've crossed this threshold so you can report it correctly on your tax return.

Reporting annuity income on your tax return

The insurance company will send you a Form 1099-R each year showing the total amount you received from the annuity. This form also indicates whether the distribution is from a may have access to or non-may have access to annuity and whether any early withdrawal penalty applies. You'll use this form to report the income on your federal tax return, typically on Form 1040.

For a may have access to annuity, you report the full 1099-R amount as ordinary income. For a non-may have access to annuity, you report only the taxable portion — the 1099-R will show the total, but you'll need to calculate and report only the earnings portion based on your exclusion ratio. Keep your annuity contract and any statements showing your original investment, because the IRS may ask for proof of how much you contributed.

If you made a mistake on a prior year's return or received incorrect information from the insurance company, you can file an amended return using Form 1040-X. Tax software and tax professionals can help you sort out the correct reporting if your situation is complex.

Inherited annuities and spousal rollovers

If you inherit an annuity from someone else, the tax rules change. A spouse can roll an inherited annuity into their own annuity or IRA, which defers tax. Non-spouse beneficiaries cannot do a rollover and must take distributions, which are taxable based on the same may have access to/non-may have access to rules that applied to the original owner.

The find Act, which took effect in 2020, changed how long non-spouse beneficiaries can stretch out inherited annuity payments. Most non-spouse beneficiaries must now withdraw the entire annuity within 10 years, which can create a large tax bill in a single year. If you've inherited an annuity, talking to a tax professional or financial advisor about the timing of withdrawals is important.

Frequently Asked Questions

Do I owe taxes on annuity money while it's still growing?

No. During the accumulation phase, before the annuity starts paying you, earnings grow tax-deferred. You owe no annual tax and don't report anything to the IRS. Tax is due only when you withdraw money or when the annuity begins its payout phase.

What's the difference between ordinary income tax and capital gains tax on an annuity?

Annuity earnings are taxed as ordinary income, not as capital gains, even if the annuity invests in stocks. This means you pay your regular income tax rate, which is typically higher than the long-term capital gains rate. This is one reason some people prefer other investments for non-may have access to money.

Can I avoid taxes by not taking annuity payments?

Not entirely. If you own a non-may have access to annuity and don't take payments, you still owe tax on earnings each year under the "inside buildup" rules — though this is less common with modern annuities. Once the annuity enters the payout phase, you cannot stop taking payments on most annuities. Check your contract for the rules on your specific annuity.

Will I owe taxes on annuity payments if I'm retired and have low income?

Yes. Annuity payments are income, and they count toward your total income for the year. Even if you're retired, you'll owe tax on the taxable portion of annuity payments at whatever your tax bracket is. However, if your total income is very low, you may owe little or no tax.

What if the insurance company sends me a wrong 1099-R?

Contact the insurance company and ask them to issue a corrected form. Keep a copy of your request. If they don't correct it, you can still file your return with the correct amount and attach a statement explaining the discrepancy. The IRS matches 1099-Rs to returns, so having documentation of the error protects you.