You pay taxes on annuity earnings, but the timing and rate depend on whether you bought the annuity with pre-tax or after-tax money

The short answer: yes, you will owe taxes on part of your annuity income. But "part" is the key word. If you funded the annuity with money you already paid taxes on, you do not pay taxes again on that portion when you withdraw it. You only pay taxes on the earnings — the growth your money made inside the annuity.

If you funded it with pre-tax dollars (like money from a traditional IRA or 401(k) rollover), then the entire withdrawal is taxable as ordinary income.

The tax rate you pay depends on your total income that year and your tax bracket. Annuity withdrawals are taxed as ordinary income, not at the lower capital gains rate, even though the money grew over time.

Key Takeaways

  • Withdrawals from annuities funded with after-tax money are only taxed on the earnings portion, not on your original contribution.
  • Withdrawals from annuities funded with pre-tax money (like IRA rollovers) are fully taxable as ordinary income.
  • Annuity income is taxed at your ordinary income tax rate, which varies based on your total income and filing status.
  • If you withdraw before age 59½ from a non-may have access to annuity, you may owe a 10 percent penalty on the earnings portion in addition to income tax.
  • The IRS uses a formula called the exclusion ratio to calculate how much of each payment is taxable when you have a mix of contributions and earnings.

How the IRS splits your withdrawal into taxable and non-taxable parts

When you start taking money from an annuity you bought with after-tax dollars, the IRS treats each payment as part return of your own money (not taxable) and part earnings (taxable). You do not get to choose which part you withdraw first — the IRS calculates a ratio that applies to every payment you receive.

This ratio is called the exclusion ratio. It divides your original contribution by the total amount you expect to receive over the life of the annuity. If you contributed $100,000 and the annuity is expected to pay you $200,000 total, your exclusion ratio is 50 percent. That means 50 percent of each payment is your money (not taxed) and 50 percent is earnings (taxed).

The IRS publishes life expectancy tables to calculate the expected total payout. Your age when payments begin and the annuity type (single life, joint life, period certain) all affect this number. If you live longer than the IRS expected, eventually all your remaining payments become fully taxable because you have recovered your entire contribution.

Pre-tax annuities: when your entire withdrawal is taxable

If you rolled money from a traditional IRA, SEP-IRA, or 401(k) into an annuity, or if you bought the annuity inside a retirement account, the entire withdrawal is taxable. There is no exclusion ratio because none of the money was after-tax to begin with.

This applies to most workplace retirement plan annuities and to annuities held inside IRAs. When you start receiving payments, you report the full amount as ordinary income on your tax return. Your employer or the annuity company will send you a 1099-R form each year showing the taxable amount.

The advantage of pre-tax annuities is that you did not pay income tax when you contributed the money, so you had more to invest. The trade-off is that you pay tax on the full withdrawal later.

The 10 percent early withdrawal penalty and its exceptions

If you withdraw money from a non-may have access to annuity (one you bought with after-tax money) before you turn 59½, the IRS charges a 10 percent penalty on the earnings portion of your withdrawal, in addition to ordinary income tax. This penalty does not explore to the part of your withdrawal that is your original contribution.

Some situations are exempt from this penalty. You can withdraw without penalty if you are disabled, if you set up a series of substantially equal periodic payments (called a 72(t) distribution), or if you are withdrawing from a may have access to longevity annuity contract (QLAC). Annuities held inside IRAs or 401(k)s have their own set of penalty exceptions tied to those account types.

If you own the annuity and are already 59½ or older, no early withdrawal penalty applies, regardless of when you bought it. Some annuities also allow you to withdraw a small percentage each year (often 10 percent) without penalty, even before 59½ — check your contract.

What form the annuity company sends you for taxes

Each year you receive annuity payments, the company will mail you a Form 1099-R by January 31. This form shows the total amount paid to you, how much is taxable, and whether any early withdrawal penalty applies. You use this form to report the income on your tax return.

Box 1 shows the total distribution. Box 2a shows the taxable amount (which may be the full amount for pre-tax annuities, or only the earnings portion for after-tax annuities). Box 7 contains a code that tells you the distribution type — code 7 means it is a normal annuity distribution, while code 8 means an early distribution subject to penalty.

If you received a distribution before age 59½ and you may have access to for an exception to the penalty, you will need to file Form 5329 with your tax return to claim the exception. The 1099-R alone does not tell the IRS that you are exempt — you have to report it yourself.

State taxes on annuity income

Most states tax annuity income the same way the federal government does — as ordinary income at your state tax rate. A few states do not tax income at all (including Florida, Texas, and Wyoming), so if you live in one of those, you only owe federal tax.

Some states offer partial exemptions for retirement income, including annuity payments, if you are over a certain age (often 59½ or 62). The rules vary widely by state. If you moved to a new state after you bought the annuity, check whether your new state taxes annuity income differently than your old one.

How annuity taxation differs from other retirement income

Annuity income is taxed differently than Social Security, which has its own formula for how much is taxable based on your total income. It is also different from may have access to dividends and long-term capital gains, which are taxed at preferential rates (0, 15, or 20 percent depending on income). Annuity withdrawals are always taxed as ordinary income, at rates up to 37 percent at the federal level.

If you have multiple income sources in retirement — Social Security, annuity payments, investment income, and part-time work — your total income determines your tax bracket, which then applies to all of it. A large annuity payment in one year can push you into a higher bracket and increase the tax on your other income too.

Frequently Asked Questions

Do I have to pay taxes on annuity payments if I am retired?

Yes. Retirement status does not change the tax rules. You owe income tax on annuity earnings (or the full amount if it is a pre-tax annuity) regardless of whether you are still working. The only exception is the portion of your withdrawal that represents your original after-tax contribution, which is not taxed again.

What if I inherited an annuity from someone else?

Inherited annuities have their own tax rules. If you inherit a non-may have access to annuity, you may owe tax on the earnings when you withdraw, but the rules depend on whether you are the spouse, a beneficiary, or a non-spouse beneficiary. Consult a tax professional, as the rules changed significantly in recent years and vary by situation.

Can I avoid taxes by not withdrawing from my annuity?

Yes. As long as the money stays inside the annuity, you do not owe tax on the earnings. Taxes are due only when you withdraw. This is one reason annuities can be useful for long-term savings — the growth compounds without annual tax drag. However, once you start receiving payments (called the annuitization phase), you owe tax on each payment according to the rules above.

Will my annuity income affect my Medicare premiums or Social Security taxes?

Yes. Annuity income counts toward your total income, which can increase your Medicare Part B and Part D premiums if your income exceeds certain thresholds. It also affects how much of your Social Security is taxable. These thresholds are based on "modified adjusted gross income," which includes annuity withdrawals.

What is the difference between a may have access to and non-may have access to annuity for tax purposes?

A may have access to annuity is one you bought inside a retirement account (IRA, 401(k), etc.) with pre-tax money. A non-may have access to annuity is one you bought outside a retirement account with after-tax money. may have access to annuities are fully taxable on withdrawal. Non-may have access to annuities use the exclusion ratio, so only the earnings are taxed. The account type determines the rule, not the annuity itself.